The Development of Pension Systems in Europe and The Role of Governance, Risk Management and External Consultants in The Change Process

International School of Management
Ph.D. Program 1hesis

The development of pension systems in Europe and the role of governance, risk
management and external consultants in the change process
By
Des Cooney
Submitted in partial IulIilment oI the requirements oI the
Doctor of Philosophy
1uly 2010
Word count 86,179
The development of pension systems in Europe and the role of governance, risk management and external consultants
in the change process
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'The more I know, the more I know how little I know...`
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Executive summary
For the European pension industry, the last three years have witnessed seismic changes in
market conditions and therein levels oI retirement beneIits that individuals can expect Irom
their pension Iunds. Set against this background is an increasing awareness oI the problems that
an ageing population will present to society and in particular the need Ior the retired population
to have a suIIicient level oI retirement income in order to sustain both themselves and the
economy. This so called 'demographic time bomb' has occurred as a result oI three main
Iactors:
The departure oI the post-war baby-boom generation Irom the workIorce;
Continued increase in liIe expectancy;
Decreased Iertility rates since the 1970`s.
In addition to market turmoil and a greying population, the burden on state national pay-as-
you-go` (PAYG) pension systems is growing with large increases in expenditure on public
pensions projected Ior most European countries. The strain on overall public Iinances has put
the acquired rights oI state retirees at risk as it is now unclear whether or not social security
systems can aIIord to IulIil existing state pension obligations. As a result, individuals who
have paid into public pension systems now have to Iace up to the prospect oI receiving reduced
beneIits upon retirement. National pension systems have thus become a source oI
macroeconomic instability across Europe, threatening to constrain economic growth, and
proving to be an inequitable provider oI retirement income.
As a consequence oI the ageing population, the responsibility will Iall on the shoulders oI a
smaller group oI active workers to support a larger group oI retirees in the Iuture. While
governments are Iorced to reduce beneIits relative to contributions Ior national pension
schemes, the emphasis is moving to employers and individuals to take matters oI retirement
into their own hands. In order to address this issue, European governments have strived to put
in place mechanisms that encourage employers to establish pension schemes on behalI oI their
workers and individuals to put aside a greater proportion oI their personal savings into pension
or liIe assurance policies geared to retirement.
Across the euro zone, the size oI the private pension Iund industry diIIers extensively ranging
Irom 1.3 times GDP in the case oI the Netherlands to one tenth oI a percent Ior France
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. Several
Iactors including the demographic structure oI the population, the Iiscal position oI
governments and socio-economic trends have contributed to signiIicant cross-country variation
in the structure oI pension Iunds and the level oI importance attached to them by individual
Member States. The gradual enlargement oI the EU as a single market and the advent oI a
single European currency has added a new dynamic to pension policy Iormulation and liIted the
reIorm issue Irom the domestic to the international arena. Global Iactors in the Iorm oI
international capital Ilows and the mobility oI labour have triggered an economic necessity Ior
EU Member States to coordinate pension systems and are shaping, and even driving the
pension reIorm agenda. Though certain Member States have undertaken signiIicant measures to
1
OECD (Ed.) (2005). Economic Survey oI the Euro Area 2005: Integrating Services Markets. Retrieved Irom
http://www.oecd.org/dataoecd/8/31/35106741.pdI
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reIorm their pension systems, there are still concerns that a number oI European countries lag
well behind.
The challenge Ior governments is to create an environment wherein the pension industry can
prosper, whilst at the same time make good on its commitments to scheme members. To
achieve this objective, legislation has Iorced retirement schemes to exert greater control on the
areas oI corporate governance, capital adequacy and risk management. The report examines
current European pension legislation and details standards and requirements that are expected
oI those operating in the arena.
In order to Irame the problem it is necessary to examine the most recent research conducted on
occupational pensions. Critique Irom leading pension specialist Iirms such as Mercer, Hewitt,
and Towers Watson is drawn upon in order to provide a comprehensive view oI the industry.
This is supported by research supplied by the Committee oI European Insurance and
Occupational Pensions Supervisors (CEIOPS), an oIIicial European regulatory body, and the
Organization Ior Economic Cooperation and Development (OECD). A considerable amount oI
work has been conducted by both international organizations in order to help governments
address pension-related issues oI economic and social concern. Views were also drawn upon
Irom the European Federation Ior Retirement Provision (EFRP), which promotes the
development oI occupational pension, and acts as a pressure group Ior the interests oI the
national pension Iund associations in their dealings with Brussels. In addition, a series oI
reports published by the Investment and Pensions Europe (IPE) added to the reservoir oI
knowledge available Ior the analysis.
Adding to the debate
The paper traces the evolving role oI pensions in society and highlights current strategies
adopted by pension Iunds as they attempt to brave the current Iinancial crisis. Particular
attention is also paid to social protection Irameworks that have been put in place to limit the
risk oI Iunds under management. The objective oI the report is to make a contribution to the
pension debate currently taking place across Europe, through a detailed analysis oI the role oI
EU institutions in the pension reIorm process. Consideration is given to recent European
pensions` legislation as Brussels takes the initiative to boost occupational pension provision.
Given that each Member State is responsible Ior the design oI its national pension
inIrastructure, the paper highlights the diversity in design and composition oI the various Iorms
oI occupational pensions in the EU, and considers the Iuture outlook oI the pension industry in
an ever-changing environment.
The analysis attempts to add to the body oI thought that already exists on occupational
pensions. Through the application oI business theory and concepts, the paper seeks to test the
hypotheses that 'the pension Iund industry is short on governance and sound risk management
and therein will struggle to meet its liabilities to members.
The research was conducted at both secondary and primary levels. In the case oI the Iormer, a
thorough literature review was conducted discussing the various pension models that currently
exist in Europe and analysing the successes and shortcomings oI the systems to date.
Meanwhile, the primary research Iocused on Iive key issues which conIront the pension
industry:
Complexity oI legislation;
Governance;
Risk Management;
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Fees;
Suitability oI products / vehicles.
The paper attempts to provide a comprehensive understanding oI all the diIIerent tasks
involved in administering a pension scheme. These include a detailed examination oI the theory
involved in the calculation oI risk Ior bonds and equities, and the processes surrounding asset
allocation in a pension Iund.
A summary oI the Iindings oI the primary research are placed at the end oI each relevant
chapter in the text. The research provided a constant supply oI issues Ior consideration that
directly impact the Iuture well-being oI Europeans. From this platIorm emerged a picture which
illustrated a lack oI harmony and transparency in pension systems and unveiled a number oI
discrepancies between walking the walk` and talking the talk`. The talk was oI transparency,
shared vision and sound risk management processes; the walk was oIten over zealous Iund
management leading ultimately to the underIunding oI pensions, and the oIIloading oI risk to
the individual.
The study demonstrated that there is a need Ior Ilexible occupational pension programs and
conIirms that they can successIully operate alongside and complement existing national
pension systems and therein encourage the movement oI labour across borders. The report
argues that the development oI suitable pension vehicles by the European Iinancial services
industry in tandem with evolving legislation is integral to the provision oI solutions Ior this
challenge. The aim oI the pan-European pension project is to create a suitable regulatory
structure in order to Iacilitate cross-border pension vehicles with a view to narrowing the
pension gap` and bringing economies oI scale to pension providers throughout the EU. From
there, the spur oI competition is likely to encourage the convergence oI national systems.
Growth in the private Iinancing oI pensions is indeed necessary to provide an adequate income
level Ior employees aIter retirement. A pan- European license enables employers to pool their
pension liabilities and assets whilst oIIering more cost-eIIicient solutions to the demographic
problems Iaced. To this end both pension and insurance-based Irameworks have been designed
to Iacilitate the complexities oI cross-border schemes.
The recent developments in the pension arena have led to many Iund administrators being
caught unawares. An industry that once enjoyed annual returns over a decade that outpaced
wage growth is now in crisis due to a shortage oI good governance and regulation. The
requirement Ior regulation is thus to be dynamic in an ever-changing environment. The
challenge is to be ahead oI the curve in legislative terms in order to prevent economies
overheating and stop runaway` stock-markets plunging over a cliII, therein damaging pension
Iund holdings.
The report concludes that it is diIIicult to choose the right moment to introduce eIIective
regulation; much political and economic commentary is made in the wake oI signiIicant events
that have taken place. The seeds oI regulatory change thus need to be sewn in advance oI
events occurring to prevent the economy being derailed. It is important thereIore to address the
elephant in the room` i.e. the level oI risk management and governance, or lack thereoI,
relating to pension Iunds.
The body oI the report is split into 7 sections:
Part I provides an overview oI the European pensions industry in terms oI its macro-
environmental setting. A PEST analysis is used to assess how political, economic, social and
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technological issues impact pension systems. In order to examine current pension structures in
Europe, a multi-pillar pension Iramework is considered comprising oI publicly managed
pension schemes, occupational pensions and voluntary retirement savings. A series oI pension
models are analysed with particular attention being given to the DeIined BeneIit (DB), DeIined
Contribution (DC) and Hybrid structures that currently dominate the advanced economies oI
the Western World.
Part II oIIers a background to modern portIolio theory and the measurement oI risk. The
greatest challenge Ior all Iund managers is to try and gauge the level oI risk involved in
successIully meeting the pension schemes liabilities over time. It is important that the manager
Iully understands risk theory so that a sound platIorm can be built Ior decision-making. The
process oI quantiIying the total risk oI investing in a portIolio oI assets is analyzed with
particular emphasis given to risk diversiIication. The Capital Asset Pricing Model (CAPM)
approach to making investment decisions is explored; this process addresses the relationship
between risk and return and calculates the cost oI capital` Ior a pension Iund in terms oI
holding capital to protect against non-hedgeable risk.
Part III conducts a review oI EU pension Irameworks and considers alternative models that are
currently being employed in the pensions and insurance sectors oI the industry. Rather than
have Member States develop a patchwork oI national pension regulations independent oI each
other, the EU has taken an integrated approach to reIorm with a view to tackling the budgetary
implications oI an ageing population and therein have more control over the Iuture dynamics oI
public expenditure.
This section examines closely the nature oI legislative reIorm that is taking shape in EU
member states. The most signiIicant step in recent years has been the creation oI a more
coordinated pension Iramework through the introduction oI a Pensions Directive in 2005
1
on
the activities and supervision of institutions for occupational retirement provision (the 'IORP
Directive), along with the Solvency II Directive (2007)
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which was designed and developed
speciIically Ior insurance company structures.
This reIorm oI the legislation seeks to recognize the diIIerentiated pension systems in Member
States and oIIers a Iramework that makes it easier to conduct activities across borders in terms
oI Iiscal, social and economic hurdles. Applying a common set oI rules, the IORP Directive
oIIers a Iorm oI European passport Ior institutions establishing occupational pension schemes.
The Directive paves the way Ior an institution registered as an IORP in one Member State to be
recognized, and therein permitted to oIIer related occupational products and services, in other
EU member countries provided that it Iully respects the provision oI the social and labour law
in Iorce in the host Member State. The reIorm trajectory oI the IORP Directive thus represents
a convergence towards a single pension model.
1
IORP Directive, DIRECTIVE 2003//Stat. 1-12 (2003), http://eur-lex.europa.eu//LexUriServ.do?uriCELEX:32003L0041:EN:HTML.
2
Commission oI the European Communities. (2007, July 10). Directive of the European Parliament and of the Council on the taking-up and
pursuit of the business of Insurance and Reinsurance- Solvencv II. Retrieved Irom The European Commission website:
http://www.europeanlawmonitor.org///text.pdI
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Alternatively, the Solvency II proposal Ior insurance companies seeks to bring about consistent
and harmonized supervision across the EU with the aim oI delivering better overall risk
management, improved mobility oI workers and a level playing Iield Ior all pension providers.
This section compares the two models with particular reIerence to governance and risk
management processes. The major distinction between these two pension models is the level oI
security extended to beneIiciaries. Occupational pension schemes do not seem to enjoy the
same level oI protection as insurance-based schemes, in terms oI saIeguards Ior solvency
capital. In addition, the Solvency II model would argue that competition in a single EU
market Ior pensions should be between providers and variations in scheme characteristics,
rather than between supervisory regimes.
The section concludes with a summary oI current opinions Irom existing European retirement
schemes on the question oI the complexities surrounding existing EU pension legislation.
Part IV addresses the key elements oI asset allocation and asset management strategy.
Investment returns are dependent on the type oI assets held in a portIolio and where and when
such assets are actually invested. Asset allocation involves the distribution oI assets among
diIIerent investment choices or classes. The investment allocation oI the Iund is oIten a
traditional mix oI asset classes which would include equities, bonds, cash, real estate, etc. The
main asset classes may thereaIter be divided Iurther into subclasses, such as small-cap stocks or
corporate bonds. The use oI alternative asset classes such as private equity, inIrastructure,
commodities and hedge Iunds are also explored.
Increased market volatility and a constantly changing environment are ongoing challenges Ior
pension Iund managers in their asset allocation strategy. As a result, the security selection
process and market timing become key aspects oI asset allocation strategy. To examine this process
in greater detail, three diIIerent asset management strategies are considered: active management,
passive management, and a core-satellite approach. Each approach is considered on its merits as a
route to achieving pension Iund investment objectives.
The impact oI currency Iluctuation and inIlation on pension schemes are also examined, with
particular attention being given to the risk that interest rates pose Ior honouring commitments.
Interest rate changes can trigger risks that may reduce the returns on cash deposits and Iixed
income securities. It is important thereIore Ior the manager to be aware oI the cause and eIIect
oI interest rate patterns and how the yield curve can aIIect projected Iunding plans.
Duration and immunization strategies are considered as models Ior pension providers to meet
their liabilities. The objective is Ior managers to invest policy holder premiums in Iixed income
securities that have the same present value to that oI the pension Iund liabilities. The analysis
thus demonstrates how duration and immunization strategies are Iit Ior purpose` in pension
Iund management.
A liability-driven approach to pension Iund management is a tactical Iorm oI asset allocation
applied as a portIolio insurance`, which essentially seeks to secure a minimum value Ior the
pension Iund at all times in order that liabilities can be met. The model builds on the risk
return approach oI portIolio management through the development oI strategies that reduce
pension Iunding volatility by aligning investments more closely with plan liabilities.
The existing research literature appeared to ignore to a large extent the complexities oI risk
management and the impact oI legislation on sponsors and trustees. Much oI the published
research is conducted by pension and management consultants that have a vested interest in
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generating inIormation relating to the industry. Consequently, some oI the more pertinent
issues oI governance have tended to be skirted over rather than debated in a more objective
manner.
Part V oI the report highlights the key growth drivers in the pension sector and gives
consideration to emerging trends that may have an inIluence on the Iuture landscape. Fund
managers, the economy, retirees, workers, companies, the environment, and productivity are all
interconnected parts oI the same system. The inter-relationship between the roles oI the various
stakeholders is examined in the Iorm oI a pension Iood chain`.
It is the task oI governance to reconcile short term tactics with the long term strategy oI the
Iund. This section outlines the Iorces Ior change in the pension industry and puts an emphasis
on schemes accepting greater responsibility by ensuring better governance and moving more
toward Iiduciary management. With scheme sponsors increasingly seeking to outsource
portIolio and risk management activities, a premium has been put on the knowledge and
understanding oI pension systems. As the operating environment becomes more complex
sponsors are looking towards the Iiduciary model Ior external advice on plan design, risk -
management strategy and the use oI alternatives as an asset class.
Part VI conducts a detailed examination oI the characteristics oI a pensions` advisory group in
the consultancy arena. Pension Iunds continuously scour the market Ior new talent with a view
to enticing specialists into the industry. There is thereIore a unique opportunity Ior a
consultancy that can demonstrate a high level oI expertise supported by a sophisticated
knowledge management platIorm to Iill the current void.
In an attempt to explore the necessary attributes oI a pension consultancy service, a series oI
business concepts originally introduced by Michael Porter in his book Competitive Advantage.
Creating and Sustaining Superior Performance (1985)
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, are applied to an existing Paris-based
company named Axis Strategy Consultants. The models employed are in the Iorm oI the Value
Chain, the Five Forces model`, and a SWOT analysis, with a view to the development oI a
suitable competitive strategy Ior the pension consulting sector. The aim oI the consultancy
group is to add value to pension Iund clients by perIorming activities in a diIIerent or better
way than competitors. It is Ior the consultancy group to advise the pension scheme sponsor on
how best to develop uniqueness or advantage Ior the scheme with a view to delivering a greater
margin oI return Ior members.
Porter`s Value Chain` oIIers a systematic means oI displaying & categorizing events Ior the
pension Iund industry. It also highlights the positioning oI pension consulting / advisory groups
in the Iield oI pension Iund activities. The next step is Ior the consultancy to identiIy the key
Iactors aIIecting competition in an industry and diagnose their underlying causes by applying
the Five Forces model. ThereaIter a SWOT Analysis examines the key internal and external
Iactors in order to determine the limits oI what can be accomplished. Internal Iactors include
company strengths and weaknesses along with the personal values oI the key implementers,
whereas external Iactors Iocus on industry opportunities and threats and the broader societal
expectations. Only aIter having conducted a systematic analysis oI the environment and the
consultancy`s position within in it, can an eIIective competitive strategy be put in place.
1
Porter, M. E. (1985). Competitive Advantage. Creating and Sustaining Superior Performance (First Edition ed.). New York: The Free Press.
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The report highlights the diIIerent areas oI expertise possessed by the Axis Strategy
consultancy and concludes that the best way Iorward would be Ior the company to collaborate
with other advisory groups and seek to exploit synergies with partners that have
complementary skills.
Pension Iund management is a journey rather than a destination, it is thus oI great importance
that there are checks and balances along the way in order to ensure that objectives and targets
are being achieved. As part oI the competitive strategy oI Axis consultants it is necessary to
employ some Iorm oI benchmarking system in order to assess relative marketplace
perIormance compared with that oI main competitors. Indicators need to be selected Ior
perIormance measurement other than investment return. The report thus outlines a series oI
benchmarking measures that ought to be established in order to monitor key Iactors such as
quality oI advice, reliability, consistency oI service etc. in terms oI importance to customers.
These also include the use oI cost reduction benchmarks to measure the eIIiciency oI the
administration oI the Iund, along with metrics relating to transaction volumes and Iee
structures.
The report considers the design oI a balanced scorecard` as a tool to systematically measure
perIormance at Iinancial and operational levels and align activities across the business platIorm
to the interests and strategic goals oI the pension sponsor. With a continuous Ilow oI
inIormation and improved internal and external communications, the report argues that the
balanced scorecard would act as a nerve centre` Ior translating strategy into action.
Part VII concludes with a series oI recommendations that address the opportunities and
challenges presented by pension reIorm.
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Table of Contents
Executive Summary .............................................................................................................. 3
Adding to the debate ..................................................................................................................... 5
Introduction........................................................................................................................... 19
Methodology ............................................................................................................................... 19
Questionnaire design................................................................................................................... 20
Sampling Irame ........................................................................................................................... 20
Data collection and analysis........................................................................................................ 20
Problems experienced ................................................................................................................. 21
Part I
Chapter 1 A macro analysis of the current European pension situation ...... 22
A} PE8T Ana|ys|s of European pens|on systems ......................................................................... 22
1. Political Analysis ................................................................................................................. 23
2. Economic analysis................................................................................................................ 24
3. Social Analysis..................................................................................................................... 24
4. Technological analysis......................................................................................................... 24
} |mpact of the outs|de env|ronment........................................................................................... 25
1. Political implications............................................................................................................ 25
a) Pressure on public pension provision ............................................................................... 25
b) Creation oI a common structure Ior pan-European pensions ........................................... 25
c) Mobility oI labour ............................................................................................................. 26
d) The development oI pension legislation ........................................................................... 27
2. Economic implications......................................................................................................... 27
a) Economic theory and pensions ......................................................................................... 27
b) The role oI private pension Iunds in Iinancial markets .................................................... 29
3. Social implications............................................................................................................... 29
a) The liIe cycle hypothesis.................................................................................................... 30
b) Building on diversity ......................................................................................................... 31
4. Technological implications .................................................................................................. 32
a) Stress testing and Iorecasting............................................................................................. 33
b) Asset allocation related issues ........................................................................................... 34
Chapter 2 Pension models .............................................................................................. 35
A} Pens|on mode|s and the ro|e of government superv|s|on......................................................... 35
1. Government and policy-driven model.................................................................................. 35
2. Employer-driven model ....................................................................................................... 35
3. Commercial-driven pension Iund model.............................................................................. 35
} 0ccupat|ona| pens|on schemes ............................................................................................... 36
1. The structure oI occupational pension Iunds ....................................................................... 36
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2. Fund structure ...................................................................................................................... 36
3. Trustees ................................................................................................................................ 37
4. Pension Iund managers and consultant ................................................................................ 37
5. Pension Iund objectives........................................................................................................ 37
6} Funded pens|on f|nanc|ng veh|c|es.......................................................................................... 37
1. Role oI Iunded and non statutory pension schemes ............................................................ 38
2. Generic pension Iunds.......................................................................................................... 40
a) Non risk sharing plans ........................................................................................................ 40
b) Risk sharing plans............................................................................................................... 41
3. DeIined beneIit (DB) systems ............................................................................................. 42
a) DB pension systems in the UK........................................................................................... 42
b) DB pension systems in the Netherlands ............................................................................ 42
4. DeIined Contribution (DC) scheme structure ...................................................................... 42
0} The sh|ft from 0 pens|on schemes ....................................................................................... 43
The German pension reIorm oI 2001 and the strengthening oI DC orientation ..................... 43
E} Recent act|v|ty |n 0 and 06 systems .................................................................................... 45
1. DB vs DC Asset allocation at end oI 2009....................................................................... 45
2. DB/DC asset split at end oI 2009......................................................................................... 46
F} Factors |nf|uenc|ng the trend towards 06 schemes ................................................................. 47
1. Governance oI DC schemes ................................................................................................. 47
2. Structural problems associated with DC schemes ............................................................... 48
3. Design options...................................................................................................................... 49
4. DC schemes and risk management ...................................................................................... 50
5. Hybrid pension schemes ..................................................................................................... 51
Part II
Chapter 3 Portfolio theory and the measurement of risk ................................. 52
A} Portfo||o theory........................................................................................................................ 52
1. Expected return .................................................................................................................... 52
2. Measures oI risk................................................................................................................... 53
3. Calculation oI the variance................................................................................................... 54
} The Yodern portfo||o theory..................................................................................................... 55
1. Calculation oI the expected return` on a portIolio oI stocks............................................... 55
2. Covariance and correlation coeIIicient ................................................................................ 56
Chapter 4 Benefits of diversification......................................................................... 58
A} Asset corre|at|on...................................................................................................................... 58
1. Naive diversiIication............................................................................................................ 59
2. The eIIicient Irontier ........................................................................................................... 60
3. Risk diversiIication in pension Iunds................................................................................... 61
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} how to assess the va|ue of d|vers|f|cat|on ............................................................................... 62
6} |mprovements |n d|vers|f|cat|on strateg|es for the future ......................................................... 63
Chapter 5 Measuring the market risk of a pension fund................................... 64
Capital asset pricing model (CAPM) ....................................................................................... 65
CAPM Example 1........................................................................................................ 67
CAPM Example 2........................................................................................................ 67
Part III
Review of EU pension frameworks
Chapter 6 The move to cross-border pension schemes ...................................... 68
Lewin`s force-field analysis for change................................................................................ 68
1. Driving Iorces Ior change in the pension industry............................................................... 69
2. Restraining Iorces Ior change in the pension industry......................................................... 69
Chapter 7 Institutions for Occupational Retirement Provisions (IORP)..... 72
A} The a|ms and structure of an |0RP........................................................................................... 72
1. Pooling oI assets and liabilities............................................................................................ 73
2. Quantitative beneIits ............................................................................................................ 73
3. Qualitative beneIits ............................................................................................................. 74
4. Structure oI a cross-border IORP......................................................................................... 74
} Sovernance - The 6omm|ttee of European |nsurance and 0ccupat|ona| Pens|ons 8uperv|sors
(6E|0P8} ...................................................................................................................................... 75
1. Regulatory abitrage .............................................................................................................. 75
2. Funding rules Ior IORP`s..................................................................................................... 75
3. Particulars oI the IORP ........................................................................................................ 77
4. EU - Social and labour law ................................................................................................. 77
5. DiIIerent types oI IORP....................................................................................................... 78
6} Techn|ca| prov|s|ons for |0RP's............................................................................................... 78
1. InIlation protection and salary indexation ........................................................................... 80
2. Interest rate used to discount the technical provisions ........................................................ 80
3. Mortality assumptions ......................................................................................................... 82
4. Expenses .............................................................................................................................. 82
5. Security mechanisms ........................................................................................................... 82
6. Ex ante security mechanisms regulatory own Iunds` and subordinated loans`.............. 83
7. Ex post security mechanisms - sponsor commitment` and guarantee Iunds` ................... 83
8. Reduction oI accrued pension rights and non-mandatory increases ................................... 84
0} The need for assessment ......................................................................................................... 85
1. Ranking ............................................................................................................................... 85
2. The development oI IORP`s in Europe ............................................................................... 86
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Chapter 8 Occupational pensions and the Solvency II draft Directive ....... 87
A} The 8o|vency || 0|rect|ve.......................................................................................................... 87
1. Success Iactors in the insurance industry............................................................................. 87
2. Key Ieatures ......................................................................................................................... 88
3. Timeline ............................................................................................................................... 88
4. The regulatory Iramework 3 Pillars .................................................................................. 88
} Sovernance of |nsurance-based pens|on schemes.................................................................. 89
1. Supervisory review process (SRP)....................................................................................... 90
2. Report on solvency and Iinancial position .......................................................................... 91
6} R|sk management funct|on of |nsurance-based pens|on schemes .......................................... 91
1. A risk overview and governance Iramework ...................................................................... 92
2. Risk assessment by risk category ........................................................................................ 93
a) Non-liIe underwriting risk .................................................................................................. 93
b) LiIe and health underwriting risk ....................................................................................... 93
c) Market risk.......................................................................................................................... 93
d) Credit risk ........................................................................................................................... 93
e) Operational risk................................................................................................................... 94
I) Liquidity risk ....................................................................................................................... 94
g) Strategic risk ....................................................................................................................... 94
h) Reputational risk ................................................................................................................ 94
0} R|sk m|t|gat|ng act|v|t|es.......................................................................................................... 94
Capital adequacy management ............................................................................................ 94
Chapter 9 Solvency II and quantitative funding requirements....................... 96
0|8 3 framework .......................................................................................................................... 96
1. Technical provisions (TP) .................................................................................................... 96
2. Solvency II and regulatory capital requirements ................................................................ 98
a) Solvency capital requirement (SCR)................................................................................... 98
b) Internal models Ior solvency capital requirements ............................................................. 99
c) Minimum capital requirement Ior Solvency II Iramework................................................. 99
Example oI MCR calculation.................................................................................. 100
d) Stress tests.......................................................................................................................... 100
e) Own risk and solvency assessment (ORSA)...................................................................... 101
I) Actuarial Iunction............................................................................................................... 102
g) Annual solvency and Iinancial condition report ................................................................ 102
h) Valuation oI assets and liabilities ...................................................................................... 103
i) Group supervision............................................................................................................... 103
Chapter 10 The economic (solvency) balance sheet and the MCoC.............. 104
A} A market cons|stent approach to r|sk management ............................................................... 104
1. Market consistent value oI assets (MVA).......................................................................... 105
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2. Market consistent value oI liabilities (MVL)..................................................................... 105
a) Expected present value oI Iuture cash Ilows and the use oI the SWAP rate .................... 105
b) The market value margin (MVM) Ior non-hedgeable risks.............................................. 106
3. The Solvency Capital Requirement (SCR) ....................................................................... 106
} Us|ng the market cost of cap|ta| (Y6o6} approach to estab||sh the YVY for non-hedgeab|e
r|sks........................................................................................................................................... 107
(i) Hedgeable risks ............................................................................................................... 107
(ii) Non-hedgeable risks ....................................................................................................... 108
1. The market value margin Ior non-hedgeable risk .............................................................. 108
2. Application oI the MCoC approach to MVM`s ................................................................ 109
3. Calculating the MCoC Ior pension Iunds .......................................................................... 109
4. The replicating portIolio ................................................................................................... 110
5. Role oI the SCR in times oI crisis ..................................................................................... 111
6} we|ghted average cost of cap|ta| (wA66} approach ............................................................. 111
An illustrative example .......................................................................................... 112
Chapter 11 Comparison of the IORP and Solvency II models ...................... 114
A} App|y|ng 0|8 3 to a 'f|na| pay' pens|on p|an .......................................................................... 114
Pension plans with risk sharing ............................................................................................ 115
} The quest for greater secur|ty for benef|c|ar|es...................................................................... 116
Summary of research findings on EU pension legislation................................................ 117
Part IV
Chapter 12 Asset allocation ....................................................................................... 118
A} Asset a||ocat|on approaches.................................................................................................. 118
1. Strategic asset allocation.................................................................................................... 118
2. Multi asset allocation ........................................................................................................ 119
} The |nf|uence of cu|ture on asset a||ocat|on........................................................................... 120
6} A current v|ew of pens|on fund asset a||ocat|on..................................................................... 121
1. European pension Iund asset evolution 1999 - 2009 ........................................................ 121
2. European pension Iund asset evolution 2007 - 2009 ........................................................ 121
3. The evolution oI European pension assets ......................................................................... 122
4. DiversiIication ................................................................................................................... 122
5. European pension Iunds under management vs GDP........................................................ 124
Chapter 13 Alternative investments ........................................................................ 125
A} hedg|ng |nstruments.............................................................................................................. 125
15
1. Use oI options .................................................................................................................... 125
2. Hedge Iunds ....................................................................................................................... 126
} Add|t|ona| asset c|asses ........................................................................................................ 127
1. Commodities ..................................................................................................................... 127
2. InIrastructure...................................................................................................................... 127
3. Private equity ..................................................................................................................... 127
4. Emerging markets .............................................................................................................. 129
6} The susta|nab|e deve|opment sector as an asset c|ass.......................................................... 130
The paradigm shiIt ................................................................................................................ 130
Summary of research findings on pension fund asset allocation..................................... 133
Chapter 14 Asset management strategy................................................................. 134
A} The quest for a|pha ................................................................................................................ 134
1. Passive management strategy ............................................................................................ 134
2. Active management strategy.............................................................................................. 134
} Yarket t|m|ng versus t|me...................................................................................................... 135
Core / satellite approach ........................................................................................................ 135
Summary of research findings on pension fund investment strategy ............................. 138
Chapter 15 Risk management and pension funds .............................................. 139
A} 6urrency and portab|e a|pha.................................................................................................. 139
1. Currency mandates Ior the institutional manager ............................................................. 140
2. Reduction in currency volatility ........................................................................................ 140
} The econom|cs of pens|on fund management........................................................................ 141
1. DeIlation v inIlation .......................................................................................................... 141
2. Interest rate risk.................................................................................................................. 142
3. EIIects oI inIlation and interest rates on pension Iunds ..................................................... 143
6} The use of bonds |n pens|on fund management..................................................................... 144
1. Factors aIIecting bond price sensitivity ............................................................................. 144
2. Development oI immunization strategies .......................................................................... 145
3. Duration ............................................................................................................................. 145
4. Bond duration calculation .................................................................................................. 146
5. Use oI bonds to meet liabilities.......................................................................................... 147
6. Pension Iunds and zero-coupon bonds............................................................................... 148
7. Yield curves ....................................................................................................................... 148
8. High yielding bonds ........................................................................................................... 149
0} The ro|e of 'swaps' |n pens|on fund management ................................................................. 149
1. Mitigation oI interest rate exposure ................................................................................... 149
2. Interest rate swaps .............................................................................................................. 150
16
3. Longevity swaps ................................................................................................................ 152
Summary of research findings on the consideration of de-risking strategies................. 154
Chapter 16 Review of the funding status of DB plans....................................... 156
A} Pens|on p|an fund|ng and the 't|me va|ue of money' .............................................................. 156
1. Rules governing Iunding levels.......................................................................................... 156
} The f|nanc|a| cr|s|s and the |mpact on fund|ng |eve|s............................................................. 158
1. UnderIunding issues in Ireland .......................................................................................... 159
2. UnderIunding issues in the UK.......................................................................................... 160
3. UnderIunding issues in the Netherlands ............................................................................ 160
4. UnderIunding issues in European multinationals .............................................................. 161
6} 6ompar|son of assets w|th ||ab|||t|es ..................................................................................... 162
Chapter 17 Asset liability management and liability driven investment 164
A} The move to ALY and L0| strateg|es...................................................................................... 164
1. Criticism oI the ALM approach ......................................................................................... 166
2. ALM and Iiduciary management ...................................................................................... 167
Chapter 18 A vehicle for the provision of sustainable income ....................... 168
Annuities ............................................................................................................................... 168
EIIect oI UK economic policy on annuity rates .................................................................... 169
Part V
Chapter 19 Maintaining standards in the pension sector................................ 170
1. Fiduciary management ....................................................................................................... 170
2. Need Ior good governance ................................................................................................. 171
3. Committing to responsible ownership ............................................................................... 172
Summary of research findings on safeguards used by pension fund trustees to minimize
risk............................................................................................................................................ 174
Chapter 20 Through the looking glass - Issues of concern for 2010............ 175
1. Solvency Issues .................................................................................................................. 175
2. Risk Management Strategy ................................................................................................ 175
3. BeneIits and stakeholders................................................................................................... 175
4. Agency issues..................................................................................................................... 175
5. Value proposition .............................................................................................................. 177
17
Summary of research findings on the perceived transparency of fees............................ 179
Summary of research findings on benchmarks used in the selection process of an
external fund manager............................................................................................................ 180
Chapter 21 Defining the pension industry of the future................................... 181
The pens|on fund journey ...................................................................................................... 181
1. Improvements in governance ............................................................................................. 181
2. Product proliIeration ......................................................................................................... 181
3. Pension design, towards a DC model................................................................................. 182
4. Organisational change new managers, new intermediaries, new competencies............. 182
5. Pressure Ior talent............................................................................................................... 183
6. New Iood chain .................................................................................................................. 183
} Srowth of a|ternat|ve strateg|es
1. New investment content ..................................................................................................... 183
2. The emergence oI sustainable development as an investment principle............................ 183
3. Stabilizing strategies .......................................................................................................... 183
4. Rebalancing oI pension Iunds ............................................................................................ 184
6} A v|ew on the future of pens|on schemes............................................................................... 187
No country Ior old men.......................................................................................................... 187
Summary of research findings on concerns for the future of the pension scheme ........ 188
Part VI
Chapter 22 The opportunity for consulting services ......................................... 189
A} Pens|on funds - Va|ue cha|n.................................................................................................. 189
6ompet|t|ve strategy: Ana|ys|s of the pens|on-consu|t|ng |ndustry and compet|tors ............. 192
1. Forces driving industry competition .................................................................................. 192
a) The bargaining power oI buyers ....................................................................................... 193
b) The bargaining power oI suppliers ................................................................................... 193
c) Intensity oI competition .................................................................................................... 194
d) Barriers to new entrants .................................................................................................... 194
e) Regulations on new entrants............................................................................................. 195
I) Threat oI substitute products ............................................................................................. 195
2. Industry attractiveness and success Iactors ........................................................................ 196
3. Importance of industry analysis ....................................................................................... 196
6ompet|t|ve strategy for Ax|s pens|on consu|t|ng serv|ces.................................................... 197
1. Internal Iactors ................................................................................................................... 197
2. External Iactors .................................................................................................................. 198
3. Strategic Iit ......................................................................................................................... 199
Performance and compet|t|ve advantage ............................................................................... 199
18
1. Service provider dependency............................................................................................. 201
2. A customer-centric approach to strategy............................................................................ 201
3. The inIormation well.......................................................................................................... 202
4. Sources oI competitive advantage...................................................................................... 202
5. The value model oI Axis Strategy Consultants.................................................................. 204
6. Five sources Iramework..................................................................................................... 204
E} enchmark|ng for pens|on adm|n|strat|on systems ............................................................... 205
1. Qualitative sources oI inIormation..................................................................................... 206
2. Sustainable competitive advantage ................................................................................... 206
3. Balanced scorecard ............................................................................................................ 207
a) The learning and growth perspective................................................................................ 208
b) The business process perspective ..................................................................................... 209
c) The customer perspective.................................................................................................. 209
d) The Iinancial perspective.................................................................................................. 209
Summary of research findings on preferences for the remuneration of outside
consultants ............................................................................................................................... 209
Chapter 23 Challenges for consulting services ................................................... 210
1. Strategy and implementation.............................................................................................. 210
2. Consultants` role in governance......................................................................................... 211
Summary of research findings on the added value of outside pension consultants....... 212
Part VII
Conclusions........................................................................................................................ 213
Recommendations - Route map to the future ...................................................... 215
Bibliography...................................................................................................................... 218
Glossary of Acronyms and Abbreviations.............................................................. 232
Appendix 1......................................................................................................................... 234
19
Introduction
How do vou swallow an elephant? One gulp at a time'
In order to solve a problem, it is necessary to break it down into manageable pieces. ThereaIter
the parts can be reassembled so as to look at the situation aIresh. The purpose oI this study is to
take a snapshot` oI the pension industry as it exists in Europe today and through a process oI
analysis, project where it will be in the Iuture. The research is not complete in its observations
and assertions, but moreover should be viewed as a work in progress`.
The role and development oI private pension provision is a key Iactor in addressing the
challenge Iaced by ageing European citizens. EU governments are becoming increasingly
aware oI the need to Ioster conditions that are conducive to saving. The analysis reveals that
there are many rules and exceptions in each Member State pension regulation. Pension systems
Iace common challenges; however each individual country has diIIerent issues that set it apart
Irom its neighbours in terms oI context (Hemerijck 2002)
1
.
In many western European countries, social insurance systems are provided primarily by the
state. Pension distributions increasingly account Ior a large part oI national insurance beneIits
in countries such as France, Germany, and Sweden. These type oI state beneIits are Iinanced by
the PAYG Iorm oI taxation, levied on both employers and employees. However, it is becoming
increasingly evident that the generous nature oI such programs acts as a disincentive Ior the
creation oI supplementary occupational schemes.
Pension Iunds play an important role in the economic and political structure oI EU states and
thus have a signiIicant impact on national government labour policies. It is necessary thereIore
that the various pension systems act in a co-ordinated manner Ior the beneIit oI all members oI
the EU. The objective oI reIorm is not to harmonise pension policies in Europe, but moreover
to create an eIIicient market. Bolkestein (2000)
2
advocated that the structure oI pensions was a
political decision Ior Member States and emphasized that the reIorm process should be
primarily concerned with increasing the eIIiciency and security oI Iunded schemes. ReIorms
are oIten a socially sensitive subject Ior Member States as each country wishes to retain its
beneIit adequacy levels within the reIorm process.
The paper analyses the evolution oI the pension Iund market set against the background oI a
trans-national political economy in Europe. A wide range oI Iorces are at play in terms oI socio
economic and political activities with many constituencies showing signs oI conIlict as opposed
to convergence along common threads.
Methodology
The research component oI this project seeks to monitor the progress oI pension schemes in
European countries in the wake oI the current Iinancial crisis. The report tests the hypotheses
that:
'the European pension Iund industry is short on governance and sound risk management and
therein will struggle to meet its liabilities to members.
1
Hemerijck, A. (2002, April). The self-transformation of the European social model(s). Retrieved Irom http://library.Ies.de/pdI-Iiles//-4/.pdI
2 Bolkestein, F. (2000, March 30). Pensions funds in the European Union. Speech presented at Financial Times` European Pensions
ConIerence , Brussels.
20
To this end the pension industry is analyzed in depth with grounded theory applied to the
various strands oI pension Iund management in order to highlight any shortIall in the existing
processes. Set against this background opportunities are explored Ior a new type oI consulting
group that would seek to engage with all stakeholders using a `balanced scorecard` approach to
the provision oI advice.
Questionnaire design
In an attempt to gather Iresh inIormation on developments in the pension sector, it was decided
to approach trustees and Iund managers Ior their opinions in the Iorm oI a survey. The
questionnaire expands upon existing work in the Iield published by Lucida plc (2009)
1
, Towers
Perrin (2008)
2
and BiIinance (2009)
3
. It seeks to add to the body oI thought by addressing a
number oI occupational pension areas that oIten slip under the radar oI multi-national
employers in Europe. Ten key issues were outlined in the questionnaire and delivered in a
multiple-choice Iormat (see Appendix 1); these questions were designed to test the above
hypotheses.
Sampling frame
It was important to select a sample oI the population that was truly representative oI the
pension Iund sector. A directory oI registered European pension Iunds was used as the
sampling Irame with existing pension schemes targeted in the UK, Holland and Ireland. These
three particular European Member States were chosen as their pension systems have proven
over the years to be in a more advanced position than their European counterparts in terms oI
structure and design.
A key objective was Ior the sample to deliver accurate inIormation that was a true reIlection oI
the current state oI the industry. To this end managers in executive positions were targeted Ior
their opinions on pension issues. Respondents were Iound to be very Iorthcoming with
inIormation, despite the already signiIicant demands on their time.
Data collection and analysis
A group-mail soItware program designed by InIacta Ltd (2010)
4
was used to deliver the
questionnaire by email to the targeted industry personnel. This soItware product oIIered a
1
Lucida PLC. (2009, October). The Pension Pulse Survev 2009. Retrieved Irom Lucida PLC website: http://www.lucidaplc.com/centre/pulse-
report-2009
2
Towers Perrin. (2008, December). The changing nature of corporate pensions in the UK. Retrieved Irom Towers Perrin website:
http://www.towersperrin.com//?countrygbr&webcGBR///Iinal.pdI
3
BiIinance. (2009, March). Pension Survev 2009. Retrieved Irom BiIinance website: F:\Integration oI European Pensions\Survey -
biFinance.mht
4
InIacta Ltd. (n.d.). GroupMail (Version 5) |Computer soItware|. Retrieved Irom http://www.group-mail.com///.asp
21
template that could be customized Ior use in an online survey and also Iacilitated the analysis oI
the data collected in graphical Iormat.
The survey was conducted in March 2010. The questions were sent to a representative sample
oI 200 European-based corporate pension plans. 50 oI those who responded were based in the
UK, 28 Irom the Netherlands, and 22 Irom Ireland. OI these schemes, 75 were DB type
structures, 18 Hybrid pension plans, and 7 Money Purchase or DC schemes. In terms oI
capital value, schemes with more than t5bn assets under management accounted Ior 18 oI
respondents, whereas pension plans with between t1 5bn represented 41 oI the group. Plans
with less than t1bn oI assets under management also accounted Ior 41 oI respondent oI the
survey.
Questions were targeted to a cross-section oI personnel involved in the management oI pension
Iunds. The largest category oI respondent was that oI Pension PortIolio Fund Manager / ChieI
Pension OIIicer at 44. Fund Administrators were the second largest group oI respondents
with 17; Trustees, Fund Secretary`s and Fund Managers each represented 11 oI
respondents, with Human Resource Directors accounting Ior 6 oI those answering the survey.
Problems experienced
A pilot study was conducted in the Iirst instance with a select number oI respondents, in order
to identiIy any obstacles that would hinder answering the survey questions. The initial Ieedback
highlighted the Iollowing design Iailings:
The subject` oI the email did not prompt a suIIicient number oI recipients to click
through to the survey itselI;
With 34 questions in the original survey, it took an average oI 5 minutes to complete;
As there were 4 pages oI questions to complete in the survey, a number oI respondents
lost interest halI way through;
Many respondents avoided the open questions` oI the survey.
The questionnaire was thus reconstructed to take into account the time constraints oI
respondents. It was decided that a much shorter questionnaire would be more successIul in
soliciting responses. A new subject` line: The Pension Siren - International pension survey,
was used to spark the interest oI the target audience. In addition, as an incentive to complete the
questionnaire, an oIIer to share the survey Iindings was made to would-be respondents.
ThereaIter a request was sent to each respondent asking Ior their permission to contact them
again with a view to gathering additional inIormation. Through the development oI an
interactive relationship with respondents, the aim is to have a Iinger on the pulse` oI the
industry so that an ongoing stream oI analysis can be conducted which helps promote initiatives
that assist in the alignment oI interests Ior all pension Iund stakeholders.
22
Part I
Chapter 1 A macro analysis of the current European pension situation
Looking backwards through the telescope
The issue surrounding an ageing population and its impact on society is perhaps the greatest
challenge oI modern times; one that may make the current Iinancial crisis pale into
insigniIicance in comparison. In order to understand Iully the scale oI the problem, it is
necessary to examine in detail all the Iorces that are at play in the wider environment. There are
a myriad oI macro-environmental issues which inIluence the European pensions landscape.
These include government policy, demographic change, tax legislation, and various trade
restrictions between member states.
A} PE8T Ana|ys|s of European pens|on systems
To help Irame these external Iactors Ior the purpose oI analysis, a PEST model (see Diagram
1.1) is applied that categorizes issues under the Iollowing headings:
Political Iactors;
Economic Iactors;
Social Iactors;
Technological Iactors.
Diagram 1.1: PEST anaIysis of the macro-environment
The PEST analysis takes the Iorm oI a checklist oI Iactors that would inIluence an organization
seeking to enter the pension-consulting arena. The PEST tool permits an examination oI the
key drivers oI change in the business environment with a view to assessing how best to position
the operation strategically.
As the external environment is constantly changing, it is diIIicult to anticipate the direction oI
business development. The aim oI the PEST exercise is thereIore to identiIy the most
signiIicant issues and assess their impact on the European pensions industry. In so doing, it is
possible to lay down the groundwork Ior a systematic evaluation oI all relevant Iactors.
23
When using the PEST Iramework it is oIten the case that certain external Iactors Iit in one or
more categories. For example, the management oI interest rate policy by the ECB, which is in
eIIect a political decision-making process, has signiIicant economic consequences to the
perIormance oI pension Iunds in member states. Similarly the passing oI legislation in terms oI
the environment would have its origins in both the political and social environment. Although
there may be overlap in certain categories it is more important to rank external Iactors in terms
oI priority. Factors that have a propensity Ior change oIten have the greatest impact on the
pensions industry in the Iorm oI external threats and opportunities.
Given that there are 27 EU member states, it would be too arduous a task to perIorm a separate
PEST analysis Ior each country as there would be many issues that are speciIic to national
governments. The most signiIicant macro-environmental Iactors have thereIore been collated
with Europe being treated as a single trading block. The objective oI using the PEST
Iramework is thus to outline the inIluences on the pensions industry at a given moment in time.
By taking this approach it is possible to Iocus on areas oI uncertainty that may impact the
industry and thereaIter pave the way Ior the development oI scenario planning techniques to
manage change and risk associated with the environment.
1. Political analysis
A political analysis examines Iactors in the external environment that are outside the control oI
consulting organizations working in the pensions industry. Such Iactors would include the
Iollowing interventions:
The regulation oI the pension industry in Europe;
The divergence oI member state pension legislation;
Mandatory retirement age oI member states;
Employment laws;
Taxation policies oI member states in terms oI dividend payments;
The impact oI the Euro;
Mandatory employee beneIit schemes;
Sustainable development and environmental issues;
Mobility oI labour;
The inIluence oI the European Court oI Justice (ECJ) on legislation;
The Iinancial crisis and legislation;
Pressure on public pension provision;
The role oI private pension Iunds in Iinancial markets;
The Corporate Income Tax Decisions oI the ECJ;
Implications oI the ECJ decisions;
The Need Ior Regulation;
Proposals Ior the ReIorm oI European Pension Systems Solvency II;
IORP;
3
rd
LiIe Directive;
Pensions Directive.
24
2. Economic analysis
Factors oI concern in the economic environment would include the Iollowing:
Interest rate changes;
Changes in exchange rates;
InIlation;
Member state intervention on the issue oI taxation oI pension Iund contributions and on
Iund growth;
Unemployment levels oI member states;
Economic growth rate;
Stock market perIormance;
Personal savings rate;
Type oI economic system in countries oI operation;
Labour costs;
Skill level oI workIorce;
Comparative advantages oI host country;
Business cycle stage (e.g. prosperity, recession, recovery).
3. Social analysis
Sociological Iactors take into consideration all events that aIIect the market and community
socially. The social and cultural inIluences on the pension industry vary Irom country to
country. These issues include:
Demographics;
Increased LiIe Expectancy;
Increasing environmental awareness;
The changing roles oI men and women within society;
Corporate Governance;
LiIestyle changes.
4. Technological analysis
Technological advances have helped design new products and processes and led to
improvements in the way business is conducted in the pensions industry. Technology is a major
driver oI eIIiciency as it contributes to cost-reduction, improves quality and leads to innovation.
Factors that have been inIluenced by technology include the Iollowing:
Innovative Risk Management Technology;
Impact oI technology on the pension product oIIering;
Impact on cost structure;
Impact on value chain structure;
Improved Iorecasting models;
Maximization oI returns through increasing eIIiciency;
Distribution network;
Improved communication with pension scheme members;
25
Customer Relationship Management.
} |mpact of the outs|de env|ronment
1. Political implications
a) Pressure on public pension provision
Globalisation, and EU enlargement has presented many challenges and opportunities Ior
European pension systems. As a result political Iorces have had a major role to play in the
process oI pension policy reIorm in an integrated Europe. Hessel (2003)
1
noted that it is oIten
social, political and cultural issues that deIine when people retire as opposed to biological. The
concept oI providing the population with pensions` originated in 1889, when the German
Chancellor Bismarck introduced a retirement age oI 70, as a Iorm oI incentive to bolster the
national army numbers. In hindsight his motives appear to have been somewhat disingenuous
in that the average liIe expectancy at the time was less than 45 years; therein the large majority
oI people died long beIore they reached the oIIicially designated retirement age Ior collecting
any beneIits.
Work by the EU on the establishment oI an internal market Ior pension Iunds began in the
1980`s. It was 10 years beIore the Iirst concrete proposals were launched by the European
Commission, and a Iurther 12 years beIore the introduction oI the Institution Ior Occupational
Retirement Provision Directive (IORP) (see chapter 7). The political attempts to implement
such a market received much public interest in recent years and represented one oI the key
priorities oI Iormer Internal Market Commissioner Bolkestein during his oIIice (Bolkestein
2000)
2
.
b) Creation of a common structure for pan-European pensions
The road towards a regulatory Iramework Ior the pension industry in Europe has been a long
and arduous journey. There have been numerous incidents oI resistance to change by
governments, oIten as a result oI the inIluence oI powerIul labour unions in shaping Member
State pension policy. This was evident in the public protest triggered by attempts to reIorm the
social security system in France during the reign oI the Alain Juppe government between1995
and1997. A similar issue oI industrial unrest occurred in Italy under the Berlusconi government
in 1996; in both incidents the public Iurore resulted in the Iall oI the respective governments.
The task Ior member states is to decide which strategy to adopt in order to encourage
employers to provide suitable retirement schemes. Pearson (2007)
3
argues that the reIorm oI
pension systems has been looming over the policy agenda oI OECD countries Ior several years
as governments grapple with the challenge oI changing demographics and unsustainably
1
Hessel, R. (2003, March). Defusing the pension time bomb. Increasing emplovment rates - A kev policv measure for maintaining sustainable
pensions in Europe. Retrieved Irom Eipascope website: http://aei.pitt.edu///34.pdI
2
Bolkestein, F. (2000, March 30). Pensions funds in the European Union. Speech presented at Financial Times` European Pensions
3
Pearson, M. (Ed.). (2007, September). Pension Reform. The Unfinished Agenda, (OECD - Policy BrieI). Retrieved Irom
http://www.oecd.org////.pdI
26
generous public pension systems.
As the overhaul oI pension systems has developed into a hot topic` oI debate among EU
governments, the European Commission has Iound itselI in the unique position oI having to act
as a domestic agenda setter` with regards pension reIorm. EU policymakers are now turning
their attention to sustainable solutions in their quest to secure an adequate liIe-long retirement
income Ior current and Iuture pensioners.
Although there has been a series oI eIIorts at reIorm on behalI oI a number oI Member States,
there has also been a diversity oI regulation with many national systems being developed and
implemented independent oI each other. The task oI obtaining consensus on so many issues
across such a diverse number oI cultures has been Iraught with many challenges and obstacles.
A primary example has been the diIIerent approaches to the transIer oI accrued pension rights
within and across EU Member States which has caused Iundamental problems Ior employees,
employers and pension providers. Other problems experienced have included a lack oI co-
ordination at times between member states and the deIerral oI decision making on important
issues. Nevertheless signiIicant progress has been made on occupational pension system
integration.
c) Mobility of labour
There has been what can only be described as a quantum leap` over the last two decades
towards the realization oI a Single European Market. Barriers to the Iree movement oI trade in
products and services have virtually disappeared, and highly eIIicient and relatively cheap
transport has made European cities accessible to all. In addition, the euro has contributed
towards a common market Ior business and led to stability throughout the European region.
Despite these signiIicant achievements, the level oI job mobility has remained relatively low
with most people opting to work in their home countries as opposed to seeking employment
across borders. Labour mobility is an essential element Ior the successIul integration oI
European member states. The unhindered movement oI labour contributes towards growth and
economic prosperity; it also helps to make the European economy more dynamic and
competitive. To this end the European Commission has worked hard in recent years in terms oI
cross border coordination to remove obstacles Ior job mobility and promote the Iree movement
and equal treatment oI workers who change country in relation to their occupational pensions
(Bolkestein 2000)
1
argued that an internal market Ior EU supplementary pensions via the
removal oI all direct and indirect obstacles to the Iree movement oI workers and services is
regarded as a solution to the pending crisis. It would 'allow private pension Iunds to take Iull
advantage oI the euro and oI the internal market, and to operate more eIIiciently. In practise,
evolution rather than revolution has guided pension reIorm in EC Member States. Whilst
countries such as Hungary and Poland have introduced major changes in a single 'big bang
approach, most other EU Member States have had a series oI reIorms to smooth the path oI
transition. This latter group includes Finland, France, Germany, and the United Kingdom
1
Bolkestein, F. (2000, March 30). Pensions funds in the European Union. Speech presented at Financial Times` European Pensions
27
d) The development of pension legislation
European pension Iunds Iace not only the consequences oI an ageing society and highly volatile
stock markets but also have to cope with a changing legal Iramework. It is important to have
regulation and good governance in order to ensure the responsible conduct oI the pension
industry. Legislative reIorm is now beginning to take shape in both old and new EU member
states with a view to the development oI a single pension model.
The EU has taken a signiIicant step towards Iorming a single EU-wide pension system through
the issuing oI the directive Ior the Institution Ior Occupational Retirement Provision (IORP).
The objective oI the directive was to create an environment wherein best practice` could
Ilourish in the pension industry whilst at the same time achieving greater convergence towards
EU goals.
A number oI European country private pension schemes are Iinanced with vehicles that have
characteristics in common with liIe insurance. Insurers have thus also evolved as major
providers oI personal pension products or act as managers oI Iunds in some jurisdictions.
As a result, a secondary Iorm oI pension Iund legislation has been developed in parallel with
that oI the IORP Directive. This alternative pension model has been developed under the
regulatory umbrella oI the Solvency II European liIe insurance legislation. Both the IORP
Directive and Solvency II models set long term horizons in meeting the liabilities oI pension
scheme members and have evolved as two competing Irameworks in terms oI pension Iund
architecture. The two models are examined in greater detail in chapter 4 oI this analysis.
2. Economic implications
a) Economic theory and pensions
Rising budget costs, and the Iinancial requirements oI European economic integration, are
major driving Iorces Ior a pan-European approach to pension reIorm. In a bid to bridge the
economic gap that threatens the old age security oI millions oI Europeans, it has been necessary
Ior Member States to closely examine their national pension systems in order to develop a way
Iorward that would be beneIicial to all.
Variants oI pension structures exist across the national systems oI EU Member States. They are
expressed in the Iorm oI a three pillar system as outlined by the World Bank in 1998 as
Iollows:
Pillar I State pension (Pay as you go - PAYG);
Pillar II Private pension schemes linked to employment;
Pillar III Individual private pension schemes (voluntary).
A multi-pillar pension Iramework comprising oI publicly managed pension schemes,
occupational pensions and voluntary retirement savings (see Diagram 2 below). The multi-
pillar system is oIten characterised by the dominant role oI the state in the shouldering oI
responsibility Ior basic pension entitlements with a view to the prevention oI poverty.
Additional beneIits are provided by supplementary occupational schemes and/or private
arrangements. Such systems are common in Denmark, the Netherlands, and UK.
The 1
st
pillar or state pension is a mandatory public pension program Iinanced by workers on a
PAYG basis. Payments are made into a reserve Iund` which pays out guaranteed beneIits to
citizens upon retirement. EU governments are increasingly promoting the development oI a
28
strong 2
nd
pillar` oI occupational pension schemes to complement state pensions. Such
schemes operate on a Iunded basis wherein the regular contributions oI both employer and
employees are invested and used to Iinance Iuture pension beneIits. The 3
rd
pillar is Iocused on
encouraging individuals to undertake additional voluntary arrangements in the Iorm oI personal
private pensions.
The diagram below highlights the structure oI the three pillars.
Diagram 1.2: the EU three piIIar pension system
Source: Verhaegen (EFRP 2006)
The distinction between the two main clusters oI social insurance systems and multi-pillar
systems is evident in the machinations oI the French system, which is dominated by a
mandatory public pension program, as opposed to the Dutch system which applies all three
pillars. However it should be noted that the current trend emerging within Europe is Ior an
emphasis on the provision oI pension products Ior the 2
nd
and 3
rd
pillar. The EFRP in its key
messages Ior Pensions in the 21
st
Century` advocated that the three pillar model reIlected the
diversity oI systems across the EU whilst at the same time bringing clarity to the European
pensions' model (EFRP 2006)
1
. Backed by a sound Iinancial system and a stable
macroeconomic environment, the EFRP argued that the model provides a natural hedge across
the economic cycles.
1
EFRP (Ed.). (2006, June 21). PENSIONS IN 21ST CENTURY - KEY MESSAGES. Retrieved Irom http://www.eIrp.org
29
b) The role of private pension funds in financial markets
Global economic Iactors and the Ilow oI international capital have inIluenced the rate oI
development oI private pension systems. Pension Iunds are stable long-term investors and play
a signiIicant role in the shaping oI the Iinancial market. They also have a role as a supplier oI
capital to private enterprises, corporations, markets and governments. The growing importance
oI pension Iunds is illustrated in the strong growth oI Iund assets which in turn enhances the
eIIiciency, depth and liquidity oI the Iinancial markets. The expansion oI the industry in the last
twenty years has delivered economies oI scale to providers and oIIered employers and
employees a wider choice and more cost-eIIective products.
Although private pension Iunds serve as providers oI liquidity and stability to the Iinancial
system, they are exposed to the risks oI the Iund becoming insolvent, investment portIolio risk,
and inIlation or interest rate risk. Due to the increasing share oI total Iinancial assets managed
by the pension Iund sector, the supervision oI occupational Iunds has thus taken on added
importance within the broader Iinancial system.
As the liabilities oI both liIe insurers and many pension Iunding vehicles have long time
horizons, both the liIe insurance and pensions business are oIten conducted via products
employing mutual Iunds as investment instruments. The so-called 'unit linked liIe insurance
policies and many types oI personal pension products such as the stakeholder plans` Iound in
the UK are examples oI such vehicles.
Tumpel-Gugerell (2008)
1
argued that 'the increasing variety oI pension Iund assets is important
Ior the pension Iund sector`s risk and return characteristics. However the mix oI assets also
aIIects the sources oI Iinancing available to the corporate sector. By investing directly or
indirectly in mutual Iunds, shares and private sector bonds, the pension Iund sector may oIIer
alternative sources oI Iinancing Ior the non-Iinancial corporate sector, and hence may act as a
substitute Ior bank Iinancing.
3. Social implications
The challenges posed by ageing societies are common to all EC countries. The implications oI
an ageing population, has led to a Iinancial awakening on the part oI Member States. Private
pension Iunds play a pivotal role in household wealth accumulation and the securing oI income
Ior an ageing population and thus will be instrumental in shaping the standard oI living in the
Iuture. The need Ior pension reIorm has risen to the top oI the agenda as the reality oI Iuture
commitments to the retired population sinks in. ReIorms under the banner oI the IORP
Directive have taken into consideration both economic and social goals. Fischer (2008)
2
notes
that occupational schemes play a signiIicant part in many EU countries and reIlect the state role
oI social partner` in developing pension legislation.
a) The life cycle hypothesis
The task Ior government is to put in place a suitable Iramework that incentivizes both
companies and individuals to save during the years oI employment so that a comIortable
1
Tumpel-Gugerell, G., Ms. (2008, November 18). Check Against Deliverv. Speech presented at European Pension Funds Congress, FrankIurt.
2
Fischer, G. (2008, November 19). Role of workplace pensions. Speech presented at European Pension Funds Congress, FrankIurt.
30
retirement can be enjoyed. To this end, the concept oI the liIe-cycle hypothesis was developed
as a suitable model by Franco Modigliani and Albert Ando (1963)
1
. The liIe-cycle hypothesis
(see Diagram 1.3) assumes that individuals consume a constant percentage oI the present
value oI their liIe income; the level oI consumption is dictated by preIerences, tastes and
income. Modigliani argued that the average propensity to consume is higher in young and old
households, where members are either borrowing against Iuture income or running down liIe-
savings. In contrast, middle-aged people tend to have higher incomes with lower propensities
to consume and higher propensities to save. The development oI company pension schemes
targeting the middle-age section oI society has thus been a welcome savings model to help
provide an adequate income level Ior employees aIter retirement.
Diagram 1.3: Life cycIe hypothesis
Source: Modigliani (1963)
Tumpel-Gugerell (2008)
2
draws attention to a recent 'old age dependency ratio calculated by
the European Central Bank (ECB) which captures the ratio oI the population aged 65 and above
to persons between 20 and 64 years. The ECB notes that by 2050, this ratio will increase to
55 Irom the current level oI around 26 in the euro area (see Diagram 1.4). It is highly
probable that the pressure on Iinancing pensions will reach its peak as the baby boomer`
generation enters retirement over the next 25 years. Fischer (2008)
3
observes that there are also
past mistakes to correct in that, while liIe expectancy has increased by 4 years in the EU over
the period between1970 to 2000, the reverse is the case Ior the average working liIe span which
has in Iact reduced by 4 years.
1
Modigliani, F., & Ando, A. (1963). The Life Cvcle Hvpothesis of Saving, Aggregate Implications and Tests (Rep.The American Economic
Review No. 53).
2
3
31
Diagram 1.4: OId age dependency ratio (65+ in % 20-64)
Source: OECD 2008
An insight into the importance oI Iunded pensions in the OECD countries is provided by the
market size, which in 2006 was valued at approximately EUR 20 trillion. Two thirds oI this
capital was invested in pension Iunds, compared to 18 accounted Ior by banks and investment
management companies and 14 in liIe and pension insurance contracts. This large share
reIlects the dynamic growth oI pension Iunds` assets in recent years. This share is even more
pronounced in the eurozone; research highlights that over the period 2004-2006 the euro area
pension Iund assets grew on average by 13.6, compared to 9.0 Ior all OECD countries
(Tumpel-Gugerell 2008)
1
.
Faced with the demographic time-bomb` many countries are attempting to adjust the
mandatory retirement age so that it is linked closer to the increased liIe expectancy oI the
population. To this end the Netherlands and the UK have proposed that the mandatory
retirement age be increased to 67 Irom 65 with a view to controlling the costs and beneIits
extended to the population on behalI oI state systems.
b) Building on diversity
It is important to note the wide diversity oI workplace pension systems in Europe.
Acknowledging and accommodating this diversity is the key to moving Iorward. Building a
consensus about the need Ior and direction oI reIorm is thereIore essential not only to make
reIorm happen but also to build a stable and sustainable pension system. Europe is changing in
terms oI the impact oI Brussels` in inIluencing social policy making. The EU's Lisbon
strategy` has encouraged the convergence oI the national social protection policies oI Member
States in order to improve the eIIectiveness oI the occupational pension inIrastructure. The
EFRP argued that a suitable occupational pension governance structure would promote the role
oI social partners whilst at the same time balancing interests oI plan sponsors and beneIiciaries
(EFRP 2007)
2
.
1
2
EFRP (Ed.). (n.d.). Annual Report 2006. Retrieved Irom http://www.eIrp.org//publications/20Annual20Report202006.pdI
32
No particular Iorm oI single retirement system is inherently superior to another. Many EU
governments have begun to promote both occupational and individual private pension
provision in order to counteract the demographic issues they now Iace. In particular,
occupational pensions have emerged as an aIIordable, eIIective and eIIicient means oI
providing Ior retirement. Such employer-led pension schemes take advantage oI economies oI
scale, and can ensure the high retirement beneIit coverage oI populations, whilst Iacilitating
intergenerational risk sharing.
4. Technological implications
Automated systems oI data collection and analysis can be used to improve the eIIiciency and
eIIectiveness oI pension Iund management. InIormation Technology (IT) is thus assisting Iund
managers in rising to the challenges presented by complex pension systems.
The collection and analysis oI data helps pension Iunds detect problems and identiIy risks in a
timely manner and supply the necessary statistics and inIormation in order to comply with
supervisory reporting requirements. The storage, processing and monitoring oI inIormation on
pension Iunds helps to ensure the saIekeeping oI Iund assets and avoid Iund mismanagement.
Data collection assists Iund managers in monitoring the Iollowing basic risks:
Operational risk;
Market risk;
Credit risk;
Funding risk;
Valuation risk and mortality (longevity) risk to a certain extent;
Governance, compliance to regulations and business practices;
Employer covenant;
Adoption and execution oI sound investment policies.
IT systems also gather inIormation on pension plan members in the areas oI:
Contract inIormation;
Pension plan;
Pension Iund.
In Germany and the Netherlands, IT systems deliver descriptive statistics on the mean`
Iunding level oI all pension Iunds, developments in the assets oI pension Iunds over time and
the mean` interest. The data also identiIies the number oI underIunded pension Iunds, the
number oI pension Iunds operating cross border and solvency requirements. The UK
monitoring systems generate statistics such as Iunding levels by type and size oI schemes,
membership types and analytical statistics such as risk scoring based on employer credit ratings
on monthly, quarterly or annual basis.
Such systems can also deliver quality inIormation on beneIit payments, commissions, return on
investment, member age histograms, Iunding ratios, and identiIy plan sponsors not paying
contributions in accordance with actuarial valuations.
33
a) Stress testing and forecasting
Technology is used to assist managers in the development oI early warning systems that help
pension schemes monitor their Iunding levels so as to ensure that they are able to meet their
liabilities to member contracts. The systems monitor the maintenance oI the regulatory level oI
capital required to absorb any prolonged stock market correction.
Stress testing and Iorecasting techniques are used by pension Iunds on an ongoing quarterly
basis to measure risks associated with credit ratings in the case oI Iixed-interest securities and
to Iorecast the surplus on the next balance sheet day. The Iorecasting also considers hidden
reserves and losses and allows managers to perIorm ratio analysis on investment limits,
commission, and solvency margins.
The sophistication oI modern day IT systems allows managers to incorporate a risk
management approach to activities through the use oI portIolio analysis and modelling
techniques and also to monitor the Iinancial situation oI the pension Iund and any developments
in the market as a whole.
German pension systems use the Iollowing key variables Ior early warning systems:
For stress testing:
Technical reserves;
The discount rate;
Own Iunds;
Value oI asset classes;
Amount oI assets with diIIerent credit ratings groups;
Interest rates Ior the diIIerent asset classes;
Solvency capital requirements.
For Iorecasting:
Variables oI the proIit and loss calculation;
Own Iunds;
Hidden reserves and losses in assets;
Bonuses declaration Ior the next year.
Source: IOPS (2007)
The common beneIits as a result oI the utilization oI IT include a systematic and standard
approach to the processing oI data, prompt action, cost and time savings, and the ability to
create a database which is more suitable Ior analysis. IOPS (2007)
1
highlighted the Iollowing
attributes oI IT systems:
Actual and past inIormation are immediately available; as a result time is not lost time
1
IOPS. (2007, August 1). Utili:ation of Information Technologies in Off-Site Supervision of Private Pension Svstems. Retrieved Irom http:/
/www.iopsweb.org
34
searching Ior it in the Iiling department;
Descriptive statistics can be used in order to receive inIormation about the whole
pension Iund market;
IT Iacilitates the introduction oI automatic cross-checking`.
IT systems show trends and allow the breakdown oI sectors in terms oI risks and needs. They
Iacilitate inIormed decision making through the processing oI inIormation, and the optimized
use oI resources in key areas via analysis oI the data. The development oI IT systems Ior the
management oI pension Iunds enhances transparency, makes prompt action possible and thus
gives scheme members greater conIidence that business is being governed correctly. Systems
are also used Ior the educational needs oI the trustees and keeping the general public inIormed
on a timely regular basis. As pension scheme structures evolve, technology will have an
increased role in the design oI risk protection strategies. Such developments will make it easier
to match a member`s age and other liIe circumstances with an optimal investment strategy.
b) Asset allocation related issues
Regulatory changes, the strengthening scientiIic evidence and the high media proIile oI climate
change have resulted in the inclusion oI clean technology and renewable energy as assets in the
core oI the pension portIolio. With the development oI technology, alternative energy sources
such as solar, wind and hydro, as well as emerging technologies such as bio-Iuels and biomass
may in the Iuture become a source oI marginal alpha. However, as concerns surrounding the
eIIects oI global warming increase it may well become desirable iI not probable that
government policy will seek to steer legislation towards sustainable development.
35
Chapter 2 Pension models
From here to retirement
One oI the problems with legislation in general is that new Iorms oI regulation are oIten
introduced in the wake oI a crisis. It is oI course easy to be wise aIter the event and proclaim
that iI pension schemes had been governed correctly in the Iirst place there would be no need to
introduce new rules. The answer going Iorward is to tighten up the processes inherent in
pension system operations.
Business models are designed to help managers approach problems in a systematic Iashion.
Such models are used as maps and are devised to simpliIy complex problems; they do not
however provide deIinitive answers to real world issues. EIIicient market theory is the
Ioundation oI modern Iinancial economics; however when the Ilawed elements oI human
nature were added to the equation, the tried and tested models that were designed to allow Iund
managers to assess the value at risk` in their asset allocation strategy, Iailed to deliver
solutions in the case oI extreme events occuring. Business models are thus not a complete and
comprehensive description oI the world; they can however oIIer insights which help in
decision-making.
A} Pens|on mode|s and the ro|e of government superv|s|on
Madero (2007)
1
identiIies a broad Iramework oI pension system styles considered by EU
governments. These include three separate approaches:
1. Government and policy-driven model: In such systems governments develop a private
sector pension inIrastructure with a view to achieving wider sociological or economic
objectives. With a low tolerance towards risk, the supervisory authority plays a
prominent and interventionist role within a directive-led regulatory Iramework.
2. Employer-driven model - Pension provision is sponsored by the employer with trustees
playing a role on supervisory issues. The government plays a limited role by
encouraging pension provision through tax-breaks and the creation oI a regulatory and
supervisory regime that provides basic saIeguards against risk taking.
3. Commercial-driven pension Iund model - These systems are market-driven in that the
decision is oIten leIt to the employer as to whether or not they wish to provide pensions
Ior employees. The pension vehicle used in this model shares the characteristics oI
Iinancial services products in terms oI motives Ior proIit maximization and corporate
governance.
The government policy-driven and the employer-driven model can be Iound at opposite ends oI
1
Madero, D. (Ed.). (2007, August 1). A Review of the Pros and Cons of Integrating Pension Supervision with that of other Financial Activities
and Services, (OECD). Retrieved Irom http://www.iopsweb.org////.pdI
36
the EU supervisory spectrum, with the commercially-driven model positioned midway. The
argument Ior specialized supervision appears to be strongest at the extremes and that Ior
integrated supervision strongest in the middle. The model that each European government
adopts oIten reIlects the Social and Labour Laws (SLL) that shape their society. The Anglo-
Saxon model practised by the UK and Ireland puts greater emphasis on the proIit motive oI the
pension provider and seeks to limit the government role to that oI inIluencing behaviour in
terms oI competence, governance and perIormance. The decision as to how much risk
management supervision is prudent Ior a given organization is always one oI context. However
in a turbulent economic climate as is being experienced at present, there is a good argument Ior
a more regulated approach to supervision in order to guard against systemic risk.
} 0ccupat|ona| pens|on schemes
During the 1990`s, many European governments became aware oI the increasing strain on state
Iinances as a result oI relatively generous commitments to prospective retirees and rising
dependency ratios stemming Irom ageing populations. Continental social security systems in
particular appear to have a tendency towards generosity in comparison to those oI the UK and
Ireland. In countries where there is high social insurance provision, such as France, the
government is determined to Iorce change through the reduction oI beneIits paid out. In other
countries such as Germany, retirement ages are been pushed upwards. All Member States
however have recognized the need to promote more progressive pension system structures.
The new structures are established as occupational pension schemes, in which the assets were
either held in trust Iunds or directly managed by Iinancial institutions.
Occupational pension schemes operate on a Iunded basis in that the employer makes regular
contributions on behalI oI its employees into a Iund that is thereaIter invested with a view to
Iinancing Iuture retirement beneIits Ior the scheme members. As they operate in the Iorm oI
collective agreements occupational pension schemes beneIit Irom quantity discounts` in terms
oI management costs. The pension plans are designed so as to Iacilitate monthly payments
Irom employers calculated as a percentage oI the individual`s gross wage. In addition, the
schemes oIten provide cover Ior biometrics risk such as death, invalidity and longevity.
1. The structure of occupational pension funds
In essence, the development oI occupational pension schemes was triggered by the rising
demand Ior Iund assets to match the long-term pension liabilities oI members. Governments
realized they had to reduce their Iinancial burden Irom unsustainable PAYG pensions and thus
designed policies to encourage the growth oI Iunded occupational pension schemes in the Iorm
oI:
a) Corporate DeIined BeneIit (DB) pensions or
b) Corporate or individual DeIined Contribution (DC) plans.
Such Iunded schemes have been developed wherein employer pension contributions are
accumulated and then used to pay beneIits Ior the people who made them.
37
2. Fund structure
The structure oI a pension vehicle can take either the Iorm oI a pension Iund or alternatively an
insurance-based Iund with beneIits not generally being distributed to members beIore the age
oI 60. Diagram 2.1 below outlines a typical plan structure.
Diagram 2.1: Pension pIan structure
Source: de Bruijne - ING Group (2005)
3. Trustees
In EU Member States such as the UK, pensions are set up as trusts with a view to holding the
assets separately Irom the sponsoring organization. Trustees therein become the legal owners oI
the assets which are held in trust Ior the beneIiciaries or members oI the pension Iund. The role
oI the trustee is to ensure that the correct investment strategy is applied in order to meet
pension liabilities as they Iall due.
4. Pension fund managers and consultants
ProIessional Iund managers are employed either in-house or in the Iorm oI external specialists
that have developed expertise in a given area. Actuarial Iirms and management consultants
have also diversiIied into the area oI occupational pensions oIIering additional services in
perIormance measurement and Iiduciary management.
5. Pension fund objectives
As in all working projects, it is important to outline the objectives oI the operation and what is
hoped to be achieved. There are oIten conIlicting views Irom various stakeholders as to what
the objectives oI a pension Iund should be. The company sponsor may wish to maximize
returns so that any surpluses can be ploughed back into the company, whereas trustees may be
more concerned with meeting Iuture liabilities with the minimum degree oI risk. The task
thereIore is to be clear on the pension Iund objectives at the outset, therein smoothing the path
Ior all parties to buy into` the chosen strategy.
6} Funded pens|on f|nanc|ng veh|c|es
More than one pension system may exist in any individual European Member State, thus
leading to the use oI a wide range oI vehicles by employers Ior the provision oI occupational
38
pensions. Diagram 2.2 illustrates the various diIIerent Iinancing vehicles employed across
OECD countries.
Diagram 2.2: Financing vehicIes used in funded pension arrangements across OECD countries in Europe (2006) - TotaI
investments in % GDP and in Cbn
Source: OECD, Pension market in focus 2007, Issue No.4
Note: 1. Book reserve` mechanisms are a non-autonomous Iorm oI pension Iunds wherein the employer undertakes to pay beneIits to his
employees and makes provision Ior commitments on the liabilities side oI his balance sheet. This provision is segregated Irom other reserves
but does not constitute a separate institutional unit Irom the employer.
2. Pension insurance contracts` are based on subscriptions paid to a liIe insurance company, which are thereaIter invested and paid out in
beneIits upon retirement. The insurance company generally underwrites the payments oI the beneIits.
1. Role of funded and non statutory pension schemes
The move towards Iunded pension schemes picked up momentum as Member State
government`s passed legislation making it mandatory. In countries such as Italy, Latvia,
Lithuania, Hungary, Poland, Slovakia and Sweden the mandatory provision oI pension schemes
has become a key element oI overall Iuture pension income.
Funded pension provision is an attempt by EU governments to address the costs that
demographic change is putting on state systems. By diverting Iunds to Iunded schemes in the
Iorm oI tax relieI Ior employers, Member States hope to reduce the strain on their PAYG
systems with a view to making pensions more sustainable. The reIorm oI statutory systems will
lead to a considerable decline in average pension replacement rates oI workers. In countries
such as Poland, Portugal, Italy, Latvia this decline could reach 15-20 percentage points;
whereas a 10-15 decline is expected in Germany, France, Sweden, Belgium, Malta, and
Sweden (Fischer 2008)
1
.
Across EU countries there are diIIerences in the legal requirements Ior employers to oIIer or
provide employees with access to occupational pension schemes and the Iorm that these take.
In the case oI provision on a purely voluntary basis; single employer occupational pension
schemes are oIten visible in Member States; in many countries however it is obligatory Ior
1
39
certain employers to participate in industry- wide occupational pension schemes (CEIOPS
2008)
1
.
In a wider European context, occupational pension systems vary across the European Economic
Area (EEA) countries. In Czechoslovakia there are no occupational pension schemes as such;
meanwhile in Poland and Latvia, there are only pure deIined contribution schemes available.
Other countries such as Austria and Slovakia oIIer beneIits to employees via book reserve
schemes`.
In countries where the overall coverage and level oI beneIits provided via mandatory
arrangements is lower, there is generally a heavier reliance on voluntary arrangements.
Diagram 2.3 below shows the coverage rate oI the major EU countries with established
occupational pension systems.
Diagram 2.3: The coverage rate of occupationaI pensions
Coverage rates oI the second pillar || 2005
Source: Centre for Research on Pensions and Welfare Policies Turin (CeRP) / EU
The pace oI adaptation to mandatory pension systems diIIers across the world. Diagram 2.4
illustrates the correlation between the replacement rates Irom mandatory pensions and the
coverage oI voluntary pensions Ior major OECD countries. In terms oI Europe, there are two
clear clusters oI countries. First, there is a range oI mainly Southern European countries
Greece, Italy, Portugal, Spain and Turkey; but also including Finland and Poland, that have
voluntary private pension coverage oI less than 10. These countries also have relatively high
1
CEIOPS (Ed.). (2008, April). Survev on Fullv Funded, Technical Provisions and Securitv Mechanisms in the European Occupational
Pension Sector. Retrieved Irom
http://www.ceiops.eu/media/docman/publicIiles/publications/submissionstotheec/ReportonFundSecMech.pdI
40
mandatory replacement rates Ior average earners. For these seven countries, the average gross
replacement rate is 71 compared with 59 Ior the OECD as a whole (Whitehouse 2007)
1
.
The second cluster consists oI eight countries with much lower mandatory replacement rates.
This group includes the Iour Anglo-Saxon oI Canada, Ireland, the United Kingdom and the
United States. However, Belgium, the Czech Republic, Germany and Japan show a similar
relationship between private pension coverage and the scale oI the mandatory pension system.
In these eight countries, the mandatory replacement rate Ior the average earner is just 38.
Diagram 2.4: Projected repIacement rate from mandatory pensions for average earners versus coverage of voIuntary
private pensions
Source: OECD Pensions at a glance; OECD private pension statistics 2008
2. Generic pension funds
Peek et al (2008)
2
observe that pension plans can be categorized as either risk sharing plans or
non risk sharing plans. Risk sharing plans contain Ieatures that allow the pension Iund to
mitigate the risk by sharing part oI it with the sponsor and/or with the plan members. In the
case oI pension plans that do not practise risk sharing, the risks stay within the pension Iund.
1
Whitehouse, E. (Ed.). (n.d.). Private Pensions - a growing role. Retrieved Irom OECD website: http://www.oecd.org////
2
Peek, J, Reuss, A, & Scheuenstuhl, G (Eds.). (2008, March). 'Evaluating the Impact of Risk Based Funding Requirements on Pension
Funds`, OECD Working Papers on Insurance and Private Pensions No 16. Retrieved Irom OECD Publishing. website:
http://www.oecd.org/dataoecd///.pdI
41
a) Non risk sharing plans
Generic pension plans that do not allow Ior risk sharing with the plan sponsor and/or the plan
members are regarded as being deIined`. DeIined pension plans are known as standard Iinal
pay` and career average` plans. The main Ieatures oI such plans are:
Final Pay Plan
The plan member receives 1 oI the Iinal salary Ior each year oI service as pension
beneIit;
BeneIits are paid as liIe-long annuities and are indexed based on inIlation;
Accrued beneIits Ior early leavers are indexed based on inIlation.
Career Average Plan
For each year oI service, the plan member earns a deIerred beneIit equal to 1 oI the
current salary;
Accrued beneIits and pensions in payment are unconditionally indexed based on
inIlation.
An additional variation to the no risk sharing` career average plan is that oI indexation only oI
pensions beneIits.
b) Risk sharing plans
The generic pension plans that do allow Ior risk sharing are career average plans which have
shared Ieatures such as additional contributions, conditional indexation and beneIit cuts (see
Diagram 2.5 below).
Diagram 2.5: Overview of generic pension funds
Source: Peek et al (2007)
42
3. Defined benefit (DB) systems
In the case oI DB schemes, the sponsoring employer agrees to provide a pension to employees
upon retirement; this Iigure is normally calculated as a percentage oI the employee's Iinal
salary, or on the basis oI the average salary over a speciIied number oI years. To meet this
obligation the employer makes regular contributions into a pension Iund created speciIically to
provide retirement beneIits to its members. The level oI contributions into such schemes is
oIten controlled by actuaries on the basis oI what is needed to honour the employer`s
commitment to plan members. ThereaIter the assets within the pooled Iund` are invested with
a view to meeting Iuture pension obligations. Characteristics oI such schemes may include
additional beneIits such as a guaranteed return, or returns indexed to inIlation.
a) DB pension systems in the UK
DB schemes in the UK can be quite complex in their structure, and as a result may act as a
deterrent to employers. Characteristics oI DB schemes in the UK include:
Limits on overIunding encourage contribution holidays;
Existence oI a pension protection Iund` which invites the risk oI moral hazard;
UnderIunding aggravated by raising accrued beneIit obligation;
Compulsory indexation;
Compulsory survivor beneIits;
UniIorm minimum Iunding.
b) DB pension systems in the Netherlands
DB schemes in the Netherlands are structured diIIerently Irom the UK. Characteristics include:
Guaranteed beneIits and returns;
Funding coverage oI 105 required;
Flexibility in increasing Iunding;
No extra capital Ior indexed beneIits required; only nominal beneIits are mandatory.
Due to the more stringent solvency requirements, Dutch schemes can boast oI an overall
reduction in the level oI risk Ior the sponsor.
4. Defined Contribution (DC) scheme structure
A DC scheme is an occupational pension wherein the scheme sponsor commits to making a
speciIied contribution, expressed as a percentage oI the employee`s salary, to the scheme on
behalI oI the employee. The beneIits ultimately paid out to employees upon retirement will
depend on the amount oI contributions paid into the scheme and the invested return oI the
money. The common name attributed to such pensions is known as money purchase schemes`.
DC schemes do not commit to an additional pension promise` over and above the contribution
into the pension Iund. Should a sponsoring employer commit to any Iurther beneIits, such a
scheme would Iall into the DB category
DeIined contribution schemes have been dominated by insurance companies in the UK. Upon
retirement, the inherent value oI an individual`s pension Iund is used to purchase a liIetime
43
income Irom an insurance company in the Iorm oI an annuity. The structure oI a DC scheme
varies Irom one EC to the next. In the UK, the concept oI a stakeholder pension` was
introduced that in eIIect limits the employer's role to the selection oI a provider and payment oI
regular contributions as determined in the plan rules. Employees thereaIter may choose which
investment Iund to enter and how much they want to pay into the scheme.
In contrast, DC Iunds in Spain distribute beneIits to members in line with the growth oI the
pension Iund; there is however no investor choice as to how the money is actually invested.
In the Netherlands, recent legislation has seen a move away Irom Iinal salary type
arrangements towards a collective Iorm oI DC or age-related DC, whereby contributions are all
Iixed. Such a collective DC scheme targets a particular level oI guaranteed beneIit as a Iinal
outcome. This level oI beneIit is however calculated by a Iormula that has no direct association
with the amount that the members contribute over the period.
Both Belgium and Switzerland have seen DC pension systems Ilourish over the last decade;
however there is still a requirement Ior providers to oIIer some Iorm oI guaranteed return to
employees.
0} The sh|ft from 0 pens|on schemes
One oI the driving Iorces behind capital market reIorm in Europe has been the perceived need
to support Iunded occupational pension schemes. Initially EU governments had looked to
reduce their dependence on PAYG systems, with Member States including Germany, Ireland,
Netherlands, Sweden, and the UK orchestrating a move to either career-average DB plans, DC
plans, or hybrid solutions which incorporate elements oI both types. However the workplace
pension has undergone even Iurther changes in the last decade with a growing trend away Irom
the traditional DB occupational pension systems in Iavour oI DC models.
Employers are increasingly seeking to distance themselves Irom the paternalistic` approach oI
pension provision Ior their staII due to rising costs resulting Irom increased liIe expectancy,
low inIlation and Ialling market yields. The current Iinancial crisis has led to a turning oI the
tide` in the structure oI employee retirement beneIits with many employers being Iorced to
close their DB schemes to new members and replace the pension oIIer with a DC arrangement.
This trend can also be witnessed in the recently acceded EU Member States where mandatory
pension systems have been introduced on a purely DC basis.
The German pension reform of 2001 and the strengthening of DC orientation
The German pension reIorms oI 2001 saw the introduction oI an additional Iunding vehicle
known as the Pension Fund (PensionsIonds), which oIIers attractive investment solutions as
Iollows:
Introduction oI DC with minimum beneIit guarantee;
Several changes to make deIined contribution-oriented plans more attractive;
Legal entitlement Ior every employee to participate in a deIerred compensation plan;
44
DeIerred taxation Ior limited contribution amounts to PensionsIonds and Direct
Insurance;
Introduction oI state subsidies Ior individual contributions into 2
nd
and 3
rd
pillar
arrangements (Riester-Rente).
As a result oI these reIorms, the previously shrinking German occupational pension system has
recovered and is once again expanding. There has thus been an increase in private sector
pension provision Irom 38 in 2001, to 46 in 2004. Recent Iigures suggest that 60 oI all
employees including those in public services now have additional pension provision (Miksa
2006)
1
.
In recent years Germany has witnessed a series oI gradual shiIts towards DC schemes (Miksa
2006). Outlined below are the Iour stages in this evolution Irom DB towards a DC Iormat:
a) DeIined BeneIit (DB)
Pre-deIined beneIit level Pay As You Go;
No capital Iunding guarantee oI liIelong pension provision;
Financial risks lie with provider in the Iorm oI either the state or an employer;
BeneIiciary bears no investment risk.
b) DeIined BeneIit contribution oriented (Hybrid)
DeIined beneIits are based on periodical assignment oI contributions;
Financing is generated internally or is Iunded by capital;
Guarantee oI liIelong pension provision;
Investment risk lies with employer;
Total risk reduced in comparison to deIined beneIit scheme structure.
c) DeIined Contribution with minimum beneIit guarantee
BeneIit is equal to the total oI contributions with a minimum beneIit guarantee;
Tax relieI on liIelong beneIit payments;
Capital Iunded in that the investment risk lies with the provider in the Iorm oI a
guarantee.
d) DeIined Contribution (DC)
BeneIit is equal to the total oI contributions invested;
Lump-sum payment possible;
Occupational old-age-provision;
BeneIiciary bears investment risks.
Source: Miksa 2006 - OECD / IOPS Global Forum on Private Pensions
1
Miksa, B., & AGI International Pensions. (2006, November). Reforming Private DB Plans. Address presented at OECD /IOPS Global Forum
on Private Pensions, Istanbul.
45
E} Recent act|v|ty |n 0 and 06 systems
The move Irom DB to DC pension structures gathered pace throughout 2009. The Iuture Ior
DB schemes is looking increasingly Iraught with danger, as employers seek to move Iurther
away Irom commitments to beneIiciaries.
1. DB vs DC - Asset allocation at end of 2009
During the last Iive years DC pension scheme assets globally have grown at a rate oI 6.4 p.a.
while DB assets have grown at a much slower pace oI 1.6 p.a (Towers Watson 2010)
1
.
Currently DC assets represent 42 oI total pension assets compared to 40 in 2004 and 32
in 1999. Although DB assets continue to represent more than halI oI total assets, the latest
Iigures reIlect the move towards DC, albeit a slowing trend. Diagram 2.6 below shows the
rising popularity oI DC schemes across countries.
Diagram 2.6: DB/DC asset spIit
Change over the 10 years to the end oI 2009
Source: Adopted from Towers Watson and various secondary sources (2010)
1
Towers Watson. (2010, January). Global Pension Asset Studv . Retrieved Irom Towers Watson website: http://www.towerswatson.com/
assets///.pdI
32
68
0
10
20
30
40
30
60
70
80
90
100
uec 1999
45
1
.
1
assets///.pdI
40
42
60
38
uec 2004 uec 2009
u8
uC
45
1
.
1
assets///.pdI
u8
uC
46
2. DB/DC asset split at end of 2009
Diagram 2.7shows the distribution oI assets in terms oI the DB / DC split across the major EU
pension systems.
An interesting development in the last decade has been the change in the pension asset
allocation on behalI oI the Netherlands, which had in the past been solidly DB oriented, and is
now showing strong signs oI a shiIt to DC schemes. Diagram 2.8 illustrates the change in the
Netherlands and the UK over the 10 years to the end oI 2009. As oI the end oI December 2009
there were 8 oI pension assets held in DC schemes in the Netherlands, up 7 percentage points
Irom 1 at the end oI 2004. In terms oI the UK, pension Iunds have also experienced a
continued shiIt to DC status, jumping Irom 33 in 2004 to 39 in 2009.
Diagram 2.8: Change in the NetherIands and the UK over the 10 years to the end of 2009
63
61
61
0 20
lrance
Cermany
lreland
neLherlands
uk
D8]DC Sp||t 2009
u8
2 1
8
98 99
92
0
20
40
60
80
100
uec 1999 uec 2004 uec 2009
D8]DC asset sp||t - Nether|ands
46
pension systems.
73
63
61
92
61
23
33
39
8
39
40 60 80 100
D8]DC Sp||t 2009
u8 uC
8
92
uec 2009
D8]DC asset sp||t - Nether|ands
u8
uC
3
33
39
93
67
61
0
20
40
60
80
100
uec 1999 uec 2004 uec 2009
D8]DC asset sp||t - Uk
46
pension systems.
39
61
uec 2009
D8]DC asset sp||t - Uk
u8
uC
47
F} Factors |nf|uenc|ng the trend towards 06 schemes
As the structure oI pension schemes develop, a more open investment architecture has emerged
with employers seeking a broader range oI solutions and products Ior their employees. Fund
managers have now entered the Iray adding investment platIorms that oIIer choice and oI
quality service to the employer and employees. They also bring credibility to the market Ior
those sponsors who want an investment-led solution in terms oI tailored portIolios. The market
is now Iragmenting and employers are looking Ior diIIerent propositions Irom those that were
available beIore. Miksa (2006)
1
observes that the trend towards DC schemes is triggered by six
developments:
The current underIunded positions oI pension plans;
Increased volatility in Iinancial markets which makes the Iunding oI retirement beneIits
less predictable;
New laws and regulations in the areas oI Iunding, solvency, and asset allocation,
as well as taxation that have made DB plans overly complex and costly;
The increase in labour mobility;
Market-based accounting standards that have resulted in the Iunding deIicits oI DB
plans being reIlected on balance sheets;
Volatile pension expenses and higher administrative costs oI DB plans.
Although the present turmoil in the world markets has highlighted the risks oI relying more
heavily on Iunded pensions, the considerations that originally led governments to begin
reducing reliance on PAYG systems appear as convincing as beIore. The trend by governments
that did not already have Iunded pensions has been Ior greater emphasis on the establishment oI
DC schemes. However, government assistance in the promotion oI DC pension schemes can
sometimes be counter-productive in terms oI the stimulation oI consumption in the economy.
Occupational pension schemes are tax advantageous to contributing parties and have stimulated
higher levels oI employee participation where the employer has taken the lead in making
contributions. As a result there is a strong correlation between economic growth and stability
in a given country and the willingness to Iund tax incentivized schemes. An example oI
such a scenario can be seen in the reluctance oI the German government in taking additional
measures to encourage supplementary contributions Ior Iear oI such a move stiIling national
consumption.
1. Governance of DC schemes
A DC scheme is eIIectively a contract between an individual and a pension Iund service
provider. Stewart (2006)
2
highlighted a series oI governance problems that DC schemes Iind
themselves conIronted with:
Who appoints the service provider?
1
Miksa, B., & AGI International Pensions. (2006, November). Reforming Private DB Plans. Address presented at OECD /IOPS Global Forum
on Private Pensions, Istanbul.
2
Stewart, F. (Ed.). (n.d.). Governance and Structural Challenges with Individual Accounts, (OECD / IOPS Global Forum Istanbul, 8
November 2006). Retrieved Irom http://www.oecd.org////.pdI
48
Who monitors their on-going service quality?
Who ensures optimal range oI investment choices?
Who ensures that external Iiduciaries IulIil their duties (i.e. guard against conIlict oI
interest)?
Stewart argues that governance should involve managerial control and organization, and
include the regulation, supervision and accountability oI management boards. The goal should
be to minimize potential agency problems or conIlicts oI interest between Iund members and
the Iund administrator with a view to improving the perIormance oI the Iund and create trust
amongst stakeholders. She puts Iorward a series oI principles with regards to DC Scheme
Governance Solutions:
a) Governance structure 'The governance structure should ensure an appropriate division oI
operation and oversight responsibilities, and the accountability and suitability oI those with
such responsibilities.
b) Governance mechanisms 'Pension Iunds should have appropriate control, communication
and incentive mechanisms that encourage good decision making, proper and timely execution,
transparency and regular review and assessment.
Other proposed DC governance solutions include:
Ensure a transparent process Ior the appointment oI external trustees, with employee
and beneIiciaries approval oI the appointment required;
ClariIy the plan sponsor`s on-going Iiduciary responsibility Ior oversight oI external
trustees;
Establish a body to undertake this role (such as the pension commissions in Spain and
Portugal);
Make sure trustee boards understand their responsibilities towards DC scheme;
Improve quality oI trustee boards (training / proper representation / independent
members);
Encourage pension Iunds to manage their governance collectively in order to share
governance burden amongst plan sponsors.
As the value oI DC assets surpasses that oI DB assets in EC countries it will be necessary to
allocate appropriate resources to the governance oI DC schemes on order to ensure that
members are beneIiting Irom added value and appropriate risk management.
2. Structural problems associated with DC schemes
Although the trend towards DC pension schemes has accelerated, the shiIt is causing concern
in some regulatory circles. The underperIormance oI Iunds in DC scheme over the last Iew
years would suggest that there is a pressing need Ior processes to be more careIully
implemented. In a working paper on 'Investment Regulations and DC pensions , Pablo
Antolin (2009)
1
, an economist at the OECD, analyses the impact oI diIIerent quantitative
1
Antolin, P. et al. (2009, July). Investment Regulations and Defined Contribution Pensions. Retrieved Irom OECD website:
49
approaches to regulating investment risk on the retirement income Irom DC schemes. He
highlights that the Iinancial crisis led to pension Iunds in countries with mandatory DC
systems experiencing losses oI 20-25 during 2008 and observes a trade-oII between
potential retirement income and protection Irom bad outcomes. The report noted that reducing
the downside risk on retirement income Irom DC pension plans "requires moving into
relatively conservative investment policies where the share oI assets allocated to bonds may
be quite large", i.e. above 60. Antolin notes that "in countries, where payments Irom DC
plans are the main source oI retirement income the cost to society oI unIavourable outcomes
are much larger, and where participation in a DC plan is mandatory, the concerns about risk
may outweigh the desire to reach potentially high replacement rates."
The dominant characteristic oI DC schemes is that the investment and longevity risk is
transIerred Irom the employer to individual employees. It is necessary thereIore Ior
regulations to be designed that would limit some oI these risks, and avoid situations where
older workers and retirees are exposed to major losses on their retirement income.
The role oI regulators in terms oI Iund governance has become increasingly important in order
to protect the rights oI individuals. The emphasis has moved to the cultivation oI greater
expertise among trustees and pension Iund boards as opposed to an increase in the number oI
such entities. It is important that trustees are well versed in their understanding oI plan member
proIiles in order to appreciate the requirements oI designing an eIIective deIault strategy. Issues
Ior consideration would include the level oI expected return required over a member`s liIetime
until retirement, and the level oI year-on-year volatility that a given member is prepared to
tolerate throughout the liIe oI the investment. Pension Iunds thus need to be measured in the
best interests oI plan members and run accordingly by Iiduciaries. To this end, Iiduciary
responsibilities and limits in terms oI saIe harbour rules` Ior DC plans need to be clearly
outlined to all stakeholders.
3. Design options
DC schemes are growing in importance throughout Europe, to the extent that they have even
become part oI the mandatory retirement systems in countries such as Estonia, Hungary and
the Slovak Republic. Although they may be an attractive proposition Ior countries that are
reIorming their systems, DC schemes that do not oIIer members investment options can
create a great deal oI uncertainty. The objective oI providing a single deIault option
irrespective oI age or other Iactors Ior all members is to limit or reduce equity exposure.
DeIault options are based on liIe-styling` strategies wherein the investment mix is
automatically rebalanced to a more conservative asset allocation as the participant nears
retirement age. However, there is also a need to pay greater attention to deIault investment
options in terms oI the ongoing suitability oI these choices, so as not to expose employees to
the risk oI underperIorming investments. The reduction oI risk to retirement income is oIten
at the cost oI lower pensions.
Jan de Geus (2007)
1
argued that sensible pension plan designs should take into account what
we know about individuals` diIIiculties in making Iinancial decisions, and consider what kind
oI regulations are needed to cater Ior these. One solution to such a problem is the statutory
minimum investment return required on DC plans in countries such as Switzerland and
Germany. De Gues observes that 'while this may be justiIied by social goals oI beneIit
1
Jan de Geus, A. (2007, November 21). Pension funds and the changing retirement landscape. Address presented at Euro Finance Week,
FrankIurt - Congress Centre.
50
adequacy, governments also need to weigh the costs in terms oI conservative investment
strategies and a lack oI innovation in pension design.
It is necessary Ior the risk-return trade-oII oI diIIerent investment portIolios to be assessed in
relation to projected retirement beneIits as opposed to short-term investment risk and return.
Therein it is also necessary to conduct additional research on the design oI suitable liIe-cycle
investment strategies that deliver an optimal investment strategy Ior an individual who
contributes regularly to a DC plan and intends to purchase an annuity at retirement.
ModiIications to liIe-cycle strategies may be necessary iI the outcomes along the journey
diIIer signiIicantly Irom that which was expected; a series oI modelling` steps may be
required to achieve this.
Employers are increasingly Iinding themselves under severe budget pressures in the current
economic climate and in many cases are unable to increase contributions to DC schemes.
Expectation that the employer alone will shoulder the burden oI retirement provision Ior
employees is unIortunately Iounded on misplaced optimism rather than realism. One
solution to this problem is thereIore Ior employees to ensure that they have made adequate
contributions to DC schemes in order to try and oIIset any market volatility.
4. DC schemes and risk management
Pension Iunds do not suIIer Irom systemic runs and/or bankruptcies. Nevertheless, a systemic
crisis may temporarily aIIect pension Iunds through a reduction in the value oI their assets. DB
schemes can be prone to any sustained turbulence in the marketplace; this may result in a
signiIicant amount oI Iinancial stress Ior all stakeholders. However, iI the system is based on
deIined contributions`, the impact oI a reduction in the pension Iunds assets would be borne
primarily by those workers that had reached retirement age at that point in time. Such is the
situation being experienced by DC schemes across Europe as a result oI the present Iinancial
crisis.
The shiIting oI investment risk and responsibility Irom employers to employees presents a
dilemma to DC schemes in times oI market turbulence. In the past, this was deemed as an
acceptable risk as long as there was a return on investment Ior scheme participants; the
prospect oI any losses being recovered quickly also led to the exuberance oI those who would
promote DC schemes. However in recent years, investment into deIined contribution schemes
has seemed like a lottery, as investors with little control over the situation watched their
retirement Iunds crash.
The market turmoil has thus posed many challenges Ior Iund managers, employers and
employees alike. Fund managers do not rely on market rallies to recoup losses in their DC
schemes; moreover they employ a mechanistic approach in order to manage the portIolio on an
ongoing basis with a view to reducing volatility and risk. Antolin (2009)
1
considered risk-
based quantitative limits, such as absolute returns and investment Value at Risk (VaR), as the
equivalent oI setting ceilings on investments in equities and other risky assets at the cost oI
losing potentially higher returns. Complex risk-based regulations, such as VaR, can lead to
1
Antolin, P. et al. (2009, July). Investment Regulations and Defined Contribution Pensions. Retrieved Irom OECD website:
51
ineIIicient, pro-cyclical investment strategies, Iorcing pension Iunds to sell equity holdings at
times oI negative returns. The limitations oI such regulations have been magniIied as a result oI
the rapid changes in market conditions. Antolin`s research paper proposes more straight
Iorward regulation, such as a quantitative limit on equities in the region oI 30-40.
5. Hybrid pension schemes
As DB schemes become less popular and move into the maturity stage oI the product liIe cycle,
the door is beginning to open Ior more innovative hybrid structures. In some countries DB
schemes with DC elements are oIIered and vice versa. It is thus possible to have a hybrid`
occupational pension scheme providing both salary-related and money purchase beneIits and
with risk being shared between employer and worker. Jan de Geus (2007)
1
questioned the role
that governments and regulators should play in the promotion oI private pensions. He argued
that there is a need to reconsider pension regulation in the light oI recent moves Iavouring DC
plans, with a view to developing more innovative solutions such as hybrid plans. Such a hybrid
solution would help schemes move Irom the polarizing positions oI DB and DC schemes and
therein be advantageous Ior plan members and other stakeholders.
Various types oI hybrid scheme may oIIer diIIerent types oI beneIit structures to diIIerent
categories oI employee. Variations oI hybrid schemes include:
A scheme which may operate like a DC scheme but which targets a speciIied level oI
beneIits at retirement;
A scheme which may operate like a DC scheme but which guarantees a
minimum rate oI investment return on contributions paid;
A scheme which may operate like a DC scheme but which guarantees a certain
annuity purchase price;
A DC scheme which guarantees that at least the sum oI contributions paid is returned.
Hybrid schemes may have a single DB or DC structure coupled with an underlying guarantee
component. The structure oI the hybrid scheme may thus incorporate both minimum
guaranteed returns and some money purchase elements. Some schemes begin as DC plans, but
switch to DB beneIits when the employee reaches a certain age in order to reduce any Iuture
risk to the retirement Iund. Additionally, Jan de Geus observes that some employers oIIer a
separate scheme, or a separate section in the main scheme, Ior highly remunerated employees
providing a higher level oI beneIits; such a set-up is known as an executive scheme.
1
Jan de Geus, A. (2007, November 21). Pension funds and the changing retirement landscape. Address presented at Euro Finance Week,
FrankIurt - Congress Centre.
52
Part II
Chapter 3 Portfolio theory and the measurement of risk
Without risk there is little opportunity for gain
In order to Iully comprehend the challenges involved in securing sustainable income levels Ior
retirees, it is important to consider how portIolio management works. The aim oI pension Iund
managers is to obtain the greatest return over time on the assets in the Iund so that
commitments to Iund members can be met upon retirement. There are many paths to Iollow in
achieving this objective; at the intersection oI all these roads is the need to understand portIolio
theory in order to be better equipped to Iace the hurdles that lie ahead. The application oI
theory alone does not guarantee success in the marketplace. The sources oI risk are generally
related to the vagaries oI the economy and driven by inIlation, credit risk and duration.
With continuous change in the environment, no single equation can be relied upon to deliver
solutions. However, through the systematic examination oI business models it is possible to
limit the amount oI risk that the Iund would be exposed to, and therein enhance the probability
oI meeting pension Iund obligations.
A} Portfo||o theory
Financial theory attempts to guide pension Iund managers on how to invest assets through the
use oI Iinancial modelling. The pension management industry is preoccupied with two main
schools oI thought:
(i) The classic riskreturn approach to Iinance
(ii) Liability matching, as practised in the insurance world.
This chapter examines the risk return relationship in the Iirst instance and moves to consider
the concept oI asset liability management.
1. Expected return
A given pension portIolio will comprise oI a range oI assets or securities; these may include
stocks, shares, mutual Iunds, bonds etc. In order to quantiIy the risk and return oI the various
assets within the portIolio, it is necessary to base investment decisions on expectations oI the
Iuture and attach probability to the likelihood oI given events occurring. ThereaIter the best
estimate` oI the possible Iuture rate oI return is ascertained by calculation oI the mean` or
expected return`, which is the average oI all the possible returns oI the portIolio securities
weighted by their probabilities. The result is the annual average return that one would expect to
receive Irom the portIolio oI assets.
53
The table below provides a probability distribution Ior the returns oI a portIolio consisting oI
stocks A and B
TabIe 3.1
State Probability Return On Return On
Stock A Stock B
1 20 5 50
2 30 10 30
3 30 15 10
4 20 20 -10
A selection oI states` are oIIered which represent the condition oI the economy at a
given period in the Iuture i.e. state 2 could represent a growth economy and state 4 a
recession.
The probability reIlects how likely it is that the state will occur. The sum oI the
probabilities must equal 100.
The last two columns present the returns or outcomes Ior stocks A and B that will occur
in each oI the Iour states.
Given a probability distribution oI returns, the expected return can be calculated using the
Iollowing equation:
N
E|R| (p
i
R
i
)
i1
Where:
E|R| the expected return on the stock
N the number oI states
p
i
the probability oI state i
R
i
the return on the stock in state i.
In this example, the expected return Ior stock A would be calculated as Iollows:
E|R|
A
.2(5) .3(10) .3(15) .2(20) 12.5
The expected return Ior stock B would be calculated as Iollows:
E|R|
B
.2(50) .3(30) .3(10) .2(-10) 20
The calculations show that Stock B oIIers a higher expected rate oI return than Stock A.
Investors would choose between the two stocks on the basis oI expected return alone; however
it is also necessary to consider the level oI risk involved in investing in a given security.
2. Measures of risk
PortIolio theory measures risk in terms oI the variance` and standard deviation` oI the
probability distribution oI returns. This process oI quantiIying the total risk oI investing in an
asset involves the consideration oI how diverse portIolio returns are Irom the average expected
outcome or mean`. The normal distribution curve is used as many oI the securities in the
54
capital market Iall into a symmetric pattern in that the distribution oI actual outcomes below the
expected value is the mirror image oI the distribution above the expected value (see Diagram
3.1).
Diagram 3.1: NormaI distribution
Standard
Deviation
The standard deviation oI returns oI securities is Iorecast by using historical inIormation and
assigning probabilities to each possible outcome. With a normal distribution there is a 2 in 3 or
68.3 chance that the return will be within 1 or -1 standard deviation oI the expected value
(the red area on the above graph). There is a 5 chance that the return will lie outside the
expected return oI or 2 standard deviations (the red and green areas). Furthermore, there is
a 99 chance oI the expected return Ialling within three standard deviations (the red, green and
blue areas).
3. Calculation of the variance
The variance, which is the square oI the standard deviation, needs to be calculated in the Iirst
instance. Squares oI the dispersion have to be used because iI the dispersions themselves were
added together, they would cancel each other out and sum to zero (RutterIord 1996)
1
.
Given an asset's expected return, its variance can be calculated using the Iollowing equation:
N
Var(R) o
2
p
i
(R
i
E|R|)
2
i1
Where:
o the standard deviation
p
i
R
i
the return on the stock in state i
E|R| the expected return on the stock
1
RutterIord, J. (1996). Measurement oI Risk and Return. In Corporate Financial Strategv (pp. 26 - 29). Walton Hall, Milton Keynes: The
Open University.
55
The standard deviation is calculated as the positive square root oI the variance:
SD(R) o o
2
(o
2
)
1/2
(o
2
)
0.5
The variance and standard deviation Ior stock A is thus calculated as Iollows:
o
2
A
.2(.05 -.125)
2
.3(.1 -.125)
2
.3(.15 -.125)
2
.2(.2 -.125)
2
.002625
o
A
(.002625)
0.5
.0512 5.12
The variance and standard deviation Ior stock B is calculated as Iollows:
o
2
B
.2(.50 -.20)
2
.3(.30 -.20)
2
.3(.10 -.20)
2
.2(-.10 - .20)
2
.042
o
B
(.042)
0.5
.2049 20.49
Although Stock B oIIers a higher expected return than Stock A, it is also considered to be
riskier since its variance and standard deviation are greater than Stock A's.
} The Yodern portfo||o theory
An additional Iactor to consider in pension Iund management is the desire Ior investors to hold
securities as part oI a diversiIied portIolio. In 1952 Harry Markowitz
1
unveiled the modern
portIolio theory (MPT) which advocated that investors Iocus on selecting portIolios based on
their overall risk-reward characteristics. The MPT demonstrated that by combining two or
more securities in a portIolio the risk can be diversiIied and thus reduced or even eliminated.
1. Calculation of the expected return` on a portfolio of stocks
The expected return` on a portIolio is computed as the weighted average oI the expected
returns on the stocks which comprise the portIolio. The weights reIlect the proportion oI the
portIolio invested in the stocks and can be expressed as Iollows:
N
E|R
p
| w
i
E|R
i
|
i1
Where:
E|R
p
| the expected return on the portIolio
N the number oI stocks in the portIolio
w
i
the proportion oI the portIolio invested in stock i
E|R
i
| the expected return on stock i
It Iollows that Ior a portIolio consisting oI two assets, the above equation can be expressed as:
E|R
p
| w
1
E|R
1
| w
2
E|R
2
|
1
Markowitz, H. (1952, March). PortIolio Selection. The Journal of Finance, 7(1), 77 - 91. Retrieved Irom http://www.math.ust.hk/
~maykwok///F/JF.pdI
56
II we thus have an equally weighted portIolio oI stock A and stock B (50 in each stock), then
the expected return oI the portIolio is:
E|R
p
| .50(.125) .50(.20) 16.25
2. Covariance and correlation coefficient
The variance/standard deviation oI a portIolio reIlects not only the variance/standard deviation
oI the stocks that make up the portIolio but also how the returns on the stocks which comprise
the portIolio vary together. Two measures oI how the returns on a pair oI stocks vary together
are the covariance and the correlation coeIIicient.
Covariance is a measure that combines the variance oI a stock`s returns with the tendency oI
those returns to move up or down at the same time other stocks move up or down. The
covariance between the returns on two stocks can be calculated as Iollows:
N
Cov(R
A
,R
B
) o
A,B
P
i
(R
Ai
- E|R
A
|)(R
Bi
- E|R
B
|)
i1
Where:
o
A,B
the covariance between the returns on stocks A and B
P
i
R
Ai
the return on stock A in state i
E|R
A
| the expected return on stock A
R
Bi
the return on stock B in state i
E|R
B
| the expected return on stock B
Since it is diIIicult to interpret the magnitude oI the covariance terms, a related statistic, the
correlation coeIIicient, is oIten used to measure the degree oI co-movement between two
variables. The correlation coeIIicient has the eIIect oI standardizing the covariance.
The MPT theory demonstrates that unless two securities are perIectly positively correlated, the
risk oI holding the two securities is less than the weighted average oI the two individual risks;
thereIore the lower the correlation between the two securities, the greater the reduction in the
portIolio risk (RutterIord 1996)
1
.
The correlation coeIIicient between the return oI two stocks can be deIined as the covariance oI
the portIolio securities divided by the product oI the standard deviations as Iollows:
o
A,B
Cov(R
A
,R
B
)
Corr(R
A
,R
B
) p
A,B
o
A
o
B
SD(R
A
)SD(R
B
)
1
Open University.
57
Where:
p
A,B
the correlation coeIIicient between the returns on stocks A and B
o
A,B
the covariance between the returns on stocks A and B,
o
A
the standard deviation on stock A, and
o
B
the standard deviation on stock B
The covariance between stock A and stock B is as Iollows:
o
A,B
.2(.05-.125)(.5-.2) .3(.1-.125)(.3-.2)
.3(.15-.125)(.1-.2) .2(.2-.125)(-.1-.2) -.0105
The correlation coeIIicient between stock A and stock B is as Iollows:
-.0105
p
A,B
(.0512)(.2049) -1.0009
Using either the correlation coeIIicient or the covariance, the variance on a two-asset portIolio`
can be calculated as Iollows:
o
2
p
(w
A
)
2
o
2
A
(w
B
)
2
o
2
B
2w
A
w
B
p
A,B
o
A
o
B
OR
o
2
p
(w
A
)
2
o
2
A
(w
B
)
2
o
2
B
2w
A
w
B
o
A,B
Note: The standard deviation of the portfolio equals the positive square root of the variance.
Armed with the above inIormation it is now possible to calculate the variance and standard
deviation oI a portIolio comprised oI 75 stock A and 25 stock B:
o
2
p
(.75)
2
(.0512)
2
(.25)
2
(.2049)
2
2(.75)(.25)(-1)(.0512)(.2049) .00016
o
p
.00016 .0128 1.28
It should be noted that the portIolio Iormed by investing 75 in Stock A and 25 in Stock B
has a lower variance and standard deviation than either Stocks A or B and the portIolio has a
higher expected return than Stock A.
58
Chapter 4 Benefits of diversification
Don't have all your eggs in the one basket
Holding a range oI assets in a pension portIolio that are similar in nature poses signiIicant risk
Ior the entire investment. PortIolio risk is a Iunction oI the correlation oI the component assets,
and thus changes in a non-linear Iashion as the weighting oI component assets change. It can be
concluded thereIore that in the case oI two securities being held in a portIolio, that are not
perIectly correlated (i.e. have a correlation coeIIicient 'p less than 1), the risk oI holding
these two shares is less than the weighted average oI the two individual risks. ThereIore the
lower the correlation between two shares the greater the reduction in the portIolio risk. The
purpose oI diversiIication is thus to eliminate the risk inherent in the individual stocks by
constructing a portIolio oI assets with little or, negative correlation to each other.
A} Asset corre|at|on
The theoretical beneIits available when investing between two asset classes are shown in the
diagram below Ior diIIering magnitudes oI correlation coeIIicient.
Diagram 4.1: Asset correIation
As the level oI correlation between asset classes A and B reduces, the diversiIication beneIits
increase and we are able to reduce the level oI the portIolio`s volatility whilst still maintaining
the same expected level oI return.
A portIolio would not be considered as properly diversiIied iI the majority oI stocks trend in the
same direction. Therein, owning value stocks and growth stocks in a portIolio is not eIIective
diversiIication as both types tend to trend in the same direction over time i.e. they are highly
correlated. Conversely, two assets are said to be uncorrelated iI they move independently to
each other as market events unIold. For example, the stock market and the bond market are two
asset classes that are relatively uncorrelated as bonds usually perIorm better when the stock
market is suIIering and vice versa. A similar trend in asset class movement is generally
experienced with property and the equity market.
Asset classes are groups oI securities that have high correlation with securities in their own
group, and lower correlations with securities in other groups. The diversiIication oI a portIolio
59
can also be achieved by diverting into additional asset classes. Real estate, derivatives, venture
capital, commodities, and private equity are some examples oI alternative classes that have
Iound their way into pension Iund portIolios. The task oI portIolio diversiIication is thus to
select a range oI classes that have a record oI negative correlation over the long term, such as
equities, commodities and property. II an asset class increases the expected return or decreases
the risk oI the portIolio, it would be considered as a potential investment. A Iund manager
would thereIore expect to earn a risk premium Ior holding such assets.
Some Iund managers adopt an opportunistic approach to risk diversiIication through actively
managing assets in the portIolio. This involves the research oI the market Ior speciIic
opportunities that may not systematically deliver rewards, but moreover that the Iund manager
holds the view that they will generate attractive returns at some time in the Iuture. It is
important to bear in mind that correlations can change over time as assets and markets evolve,
and to recognize the need to take a long term approach when considering the selection oI assets
and their correlation to each other.
1. Naive diversification
In order to understand the beneIits oI portIolio diversiIication in the Iuture, it is essential to
understand what might have gone wrong with the approach that many Iund managers have
adopted to date.
PortIolios can be naively diversiIied` as a result oI the selection oI an increasing number oI
stocks that trend in similar directions. In such circumstances any risk reduction is solely oI a
speciIic risk` nature wherein individual stock Iactors cancel each other out. However, the
market risk, which aIIects all stocks in the portIolio, invariably remains. Fund managers`
recognize that the selection oI ever more stocks in a portIolio results in greater overlap and thus
less diversiIication. The total risk oI a portIolio containing 10 diIIerent shares would typically
represent 50 oI the average risk oI one oI the constituent shares. With 30 shares this
percentage may reduce to 30 oI the average risk oI one oI the constituent shares; beyond this
Iigure the potential Ior risk reduction Ialls even Iurther. The chart below suggests that the
majority oI risk-reduction beneIits can be gained with a portIolio oI circa 10 stocks provided
they are Irom diIIerent asset classes and representative oI the market as a whole.
Diagram 4.2: Risk reduction through diversification
59
adopted to date.
59
adopted to date.
60
2. The efficient frontier
Markowitz (1952)
1
argued that every combination oI assets can be plotted in a risk-return
space, with the collection oI all such possible portIolios representing the opportunity set` Ior
the investor. Pension Iund managers will systematically calculate the correlation coeIIicient oI
diIIerent asset classes with a view to producing optimal portIolios; optimal in the sense that they
oIIer the best return-to-risk ratio Ior the Iund (see Diagram 4.3 below). The range oI potential
outcomes or set oI optimal portIolios is called the eIIicient Irontier and is positioned along the
upper edge oI the achievable region; with any combinations along this curve representing
portIolios Ior which there is a higher return Ior the same level oI risk or a lower risk Ior the
same return than any other possible portIolio on the curve.
0|agram 4.3: The eff|c|ent front|er
The eIIicient Irontier is eIIectively the intersection oI the set oI portIolios with minimum
variance` and the set oI portIolios with maximum return. An investor would chose between
eIIicient portIolios along the curve on the basis oI which risk-reward trade oII best suits their
personal risk proIile. A typical portIolio positioned on the eIIicient Irontier would be one that is
most highly diversiIied i.e. the market portIolio` or market index. Less diversiIied portIolios
would tend to be positioned below the Irontier and are considered to be suboptimal in that a
rational investor would only seek to buy the eIIicient portIolio.
A portIolio consisting oI the least volatile stocks would be positioned at the bottom leIt oI the
eIIicient Irontier and would be expected to underperIorm the tangency portIolio, Iurther up and
to the right. However, in the discussion on risk and return, it should be noted that low volatility
stocks with a minimum variance can outperIorm the cap-weighted portIolio that is assumed to
sit on the tangent. It is also probable that such stocks would lag behind whenever momentum
takes over.
1
~maykwok///F/JF.pdI
60
Markowitz (1952)
1
takes over.
1
~maykwok///F/JF.pdI
60
Markowitz (1952)
1
takes over.
1
~maykwok///F/JF.pdI
61
The beneIits oI diversiIication increase as the number oI non-perIectly correlated asset classes
included in the portIolio rises. The diagram below displays the eIIicient Irontier` created when
a number oI diIIerent asset classes are introduced to the portIolio.
Diagram 4.4: The efficient frontier with added asset cIasses
Source: Mercer 30 April 2009
DiversiIication may be used to reduce the non-systematic risk associated with a portIolio.
However, a portIolio will always retain an element oI non-diversiIiable or market` risk. The
goal oI diversiIication is thus to minimize the risks Ior which the Iund manager does not expect
to be rewarded; or alternatively to only accept risk in the portIolio iI one expects to be
rewarded Ior that risk.
3. Risk diversification in pension funds
DiversiIication can eliminate the risk that is speciIic to individual stocks, but not the risk that
the market as a whole may decline, and in so doing take all pension Iund stocks with it. To
address this situation pension Iund managers would invest in more deIensive` stocks that are
less sensitive to market Iluctuations.
The recent Iinancial crisis witnessed the breakdown oI the diversiIication principal that having
a diverse range oI asset classes in a portIolio, would protect investors against a collapse in the
market. The year 2008 resulted in many portIolios displaying a correlation oI 1, with
diversiIication strategies having a limited eIIect in the volatile marketplace. The problem
experienced by pension Iund managers was that the asset classes to which they had turned in
order to diversiIy risk, such as real estate, commodities, equities etc, were all linked to the real
economy. As a result the diversiIication oI the portIolio did not deliver the level oI risk
management that the Iund managers had expected. The diversiIication process itselI thereIore
needs to be managed with the Iund manager adopting a view as to what is the best time to
invest in` and divest Irom` various asset classes.
61
61
62
} how to assess the va|ue of d|vers|f|cat|on
On examination oI the return on pension Iund assets in the UK throughout 2008/9, it transpires
that the average portIolio showed a 15 20 alternative asset diversiIication. PortIolio theory
suggests that using a typical mean-variance optimization analysis results in portIolios becoming
eIIicient when diversiIied; it should be noted thereIore that there are always exceptions to the
rule oI theory, as witnessed by the number oI well-diversiIied pension Iunds that have suIIered
during the recent market crisis. Lace (2009)
1
suggests that one oI the answers to this problem
may lie in the design oI the models themselves. 'The optimization process is based on a set oI
assumptions Ior expected return, risk and the correlations between asset classes. The value oI
the optimization, and hence the ultimate diversiIication oI the portIolio, is based entirely on the
value oI these assumptions. In terms oI diversiIication, it is particularly important Ior investors
to recognize that correlations between asset classes are not static, and thus neither is the risk
associated with a particular investment strategy.
The upheaval in the stock-markets since the beginning oI 2008 has highlighted the limitations
oI diversiIication. Although the best diversiIied Iunds have perIormed better than their peers, it
is now becoming apparent to schemes that a signiIicant amount oI alternative asset classes that
were adopted have turned out to be repackaged traditional assets in the end.
In addition, it would also appear that globalization is having an impact on the eIIectiveness oI
diversiIication. While there are beneIits Irom having a wider investment opportunity set Irom
which to build a more diversiIied portIolio, the increasing co-integration oI global stock-
markets is having the opposite eIIect by increasing the correlation between these markets and
thereIore adding to the level oI portIolio risk. Lace illustrates this point by drawing attention to
the increasing correlations between UK equities and both global and emerging market equities
as shown in the diagram below.
Diagram 4.5: CorreIation between UK equities and both gIobaI and emerging markets
1
Lace, C. (Ed.). (2009). How to access the value of diversification. Retrieved Irom
http://www.mercer.com/.htm?siteLanguage100&idContent1344410
63
Source: Mercer (2009)
Other Iactors in the short term such as restrictions in the credit market, government intervention
and a decline in investor sentiment may have an impact on the ability oI asset classes to
diversiIy risk, oIten regardless oI underlying Iundamental conditions in these markets. Diagram
4.6 displays the rolling correlations between UK equities and some oI the other main asset
classes over three year periods.
Diagram 4.6: between UK equities and other asset cIasses
Source: Mercer (2009)
The situation may be exacerbated when there is a speculative bubble, wherein a number oI
diIIerent asset classes are overvalued, including those originally viewed as being diversiIiers.
Should a common event occur that leads to a correction in the market, the result will be a spike
in the correlations between asset classes and thence the loss oI any diversiIication beneIit.
6} |mprovements |n d|vers|f|cat|on strateg|es for the future
Using the volatility oI returns as the sole proxy Ior risk should not be relied upon to provide all
the answers Ior the diversiIication oI a portIolio. It is important to consider the assumptions
underlying the mean-variance optimization model as the risk measure within the optimization
process can turn out to be one-dimensional. To understand risk it is necessary to examine all
the various risk Iactors that drive returns and how they interact with one another.
The use oI risk Iactors to determine an optimal investment strategy relies on a combination oI:
The premise that risk should only be accepted in the portIolio iI there is some
expectation oI a reward Ior that risk;
The understanding that there are a number oI diIIerent investment risks` that can
drive returns.
64
Lace (2009)
1
observes that 'a typical pension Iund might structure its portIolio with an asset
allocation strategy that is eIIicient Irom a mean-variance perspective but that is over-exposed to
a single risk Iactor. An analysis oI the risk Iactors associated with the portIolio is thereIore
crucial to understanding where its returns (and risks) are likely to come Irom. Such an analysis
is depicted in Diagram 4.7 below Ior a typical portIolio.
Diagram 4.7: Breakdown of portfoIio risk factors
Source: Lace (2009)
Lace continues on this perspective arguing that 'the Iactors that are driving the returns within
the portIolio are not particularly diversiIied. It is this perspective that may encourage investors
to exploit Iurther the diversiIication beneIits oI other, non-traditional asset classes. For
example, pension Iund investors may look to exploit their ability to take a longer term view and
decide to allocate a higher proportion to those asset classes that reward suppliers oI liquidity.
Being able to analyze a portIolio in this way Iacilitates more eIIicient diversiIication by
allowing investors an added dimension Irom which to consider the risks within their portIolio.
1
65
Chapter 5 Measuring the market risk of a pension fund
'Never put off until tomorrow what vou can do the dav after tomorrow.`(Mark Twain)
The market portIolio oI the pension Iund securities will be aIIected by changes in
macroeconomic events such as interest rates, monetary policy, government spending, oil prices
and Ioreign exchange rates. The objective is to deIine and measure the level oI risk exposure in
terms oI the pension Iunds sensitivity to Iluctuations in returns on the market portIolio. The
volatility oI the Iunds securities is called the Iunds beta.
The beta oI a share is a measure oI how it is expected to move relative to the market as a whole.
The beta oI a portIolio is the average oI the beta oI the securities in the portIolio, weighted by
the investment in each security. A well diversiIied pension Iund that includes a range oI
securities would be deemed to be representative oI the market portIolio or market index and
therein have an average beta equal to 1.000.
Investors require higher levels oI expected returns to compensate them Ior higher expected risk.
High beta securities, such as technology stocks, tend to be aggressive and perIorm better than
average iI the market rises and worse than average iI the market Ialls. Low beta stocks, such as
Iood manuIacturing companies, have a beta below the market portIolio oI 1.
The least risky investment to be held in a Iund is a government Treasury bill, which oIIers a
Iixed return irrespective oI what happens to the market. The beta oI a Treasury bill is zero, as
opposed to the market portIolio oI common stocks which has a beta oI 1. The diIIerence
between the return on the market and the interest rate on Treasury bills is known as the market
or equity risk premium (ERP).
Capital asset pricing model (CAPM)
Investors in a pension Iund are mainly concerned with the risk oI their portIolio in general
rather than the risk oI the individual securities in the portIolio; this market risk` is avoided by
diversiIication oI assets held in the portIolio. The CAPM oIIers the pension Iund manager a
Iormula Ior the pricing oI assets and establishes rules Ior making investment decisions thus
providing the manager with the scope to mathematically project how the commitment to Iund
members can be met.
The CAPM adds three assumptions to portIolio theory:
markets are perIect in that there are no transaction or taxation costs
All investors have the same market inIormation available to them at the same time
Investors can borrow or lend at the risk-Iree rate oI interest
66
Diagram 5.1: CapitaI market Iine
The risk-Iree asset oIIers an additional opportunity to investors in the Iorm oI investment into
vehicles such as government bonds or Treasury bills that guarantee a Iixed interest return. A
new set oI investment combinations can thus be produced in the Iorm oI a straight line as they
are a combination oI risk-Iree assets and risky portIolios (see Diagram 5.1 above). All
portIolios on this line, which runs at a tangent to the opportunity set or eIIicient Irontier`, oIIer
superior returns Ior each level oI risk. As a result investors would seek to hold portIolios on the
capital market line` which are combinations oI the risk-Iree rate (R
I
) and the market portIolio (M)
and therein achieve the objective oI optimization.
The CAPM addresses the relationship between risk and return in that the expected risk
premium on any security is equal to its beta times the market risk. II a security's beta is known
it is thereaIter possible to calculate the expected return Ior the investor. The expected return oI
a security is thus the risk Iree rate plus a risk premium which is related to the beta oI the share
or the portIolio.
The CAPM via the capital market line` Iacilitates the calculation oI the market risk premium`,
which is the diIIerence between the expected market rate oI return and the risk-Iree rate oI
return Ior a security as Iollows:
E (R
i
) - R
I
E(R
M
) - R
I
)
i
or
E (R
i
) R
I

i
x (E(R
M
) - R
I
)
Where:
R
I
the risk Iree rate
E|R
i
| the expected return on stock i
R
M
the expected return on the market portIolio

i
the beta oI the individual security
Should an investor decide that the preIerred risk-return combination is the risk-Iree asset and the
market portIolio, this would be calculated as beta () oI M and (1 ) oI the risk Iree rate, R
I
.
67
The expected return would be:
(1 ) R
I
x E(R
M
)
or
R
I
x (E(R
M
) - R
I
)
The investor return would thereIore be a premium over the risk-Iree rate, which would be equal
to the market risk premium` multiplied by .
In the equation below, the expected return uses the Beta coeIIicient Ior security i` to measure the
variance oI the return on stock i` with that oI the market portIolio.
i
Cov(R
i
,R
M
)
Var (R
M
)
or
i
Corr
iM
x SD
iM
/ SD
M
The CAPM equation is thus:
E (R
i
) R
I

i
x (E(R
M
) - R
I
)
Where:
E(R
i
) the required return Ior the individual security
R
I
the risk-Iree rate oI return

i
the beta oI the individual security
R
M
the expected return on the market portIolio
(R
M
- R
I
) is called the market risk premium
The CAPM equation can thus be used to Iind the value oI one oI the variables listed above,
provided that the value oI the other variables is known. An example oI this is as Iollows:
CAPM example 1
The required return on a stock with a risk-Iree rate oI 8, an expected return on the market
portIolio oI 12, and a Beta oI 2 would be calculated as Iollows:
E(R
i
) R
I

i
(R
M
- R
I
)
E(R
i
) 8 2(12 - 8)
E(R
i
) 16
The required rate oI return should at this stage be compared to the expected rate oI return and a
decision made as to invest in the stock or not. An investment would only be made iI the expected
rate oI return exceeded the required rate oI return.
CAPM example 2
Alternatively, the calculation oI beta on a stock with an expected return oI 12, a risk-Iree rate oI
4, and an expected return on the market portIolio oI 10 would be conducted as Iollows:
12 4
i
(10 - 4)
i
12 - 4
10 - 4
i
1.33
68
The objective oI a pension Iund manager should thus be to obtain a required return oI 2 or 3
above the risk Iree rate through the diversiIication oI risk using asset classes that are relatively
uncorrelated such as equities and bonds.
The use oI the CAPM proves that investment in a series oI individual stocks is not necessarily a
wise approach to risk management. It is possible to duplicate the reward and risk characteristics
oI any security just by using the right mix oI cash with the appropriate asset class or group oI
securities that has high correlation with securities in the same group.
Modern portIolio theory has helped pension Iunds steer towards the relative risk properties oI
securities and into the world oI diversiIication and beta. With the the improvement in computer
systems it is now possible to systematically identiIy risk Iactors an develop indexation and
specialization by country, regions, sector and market cap. To this end, Iund mangers` that
practice MPT tend to avoid stocks, and instead build portIolios out oI low cost index Iunds.
The CAPM has its limitations as a model Ior pension management in that results are Iocused on
static solutions to portIolio problems and oIten ignore the time dimension. There is an
argument Ior the CAPM to be revamped in order to incorporate market movements, and their
impact on all beta and manager decisions. To achieve this it is necessary Ior Iund managers to
establish a set oI rules that relate to speciIic states oI the world. An optimal portIolio needs to
be developed Ior each state, supplemented by a dynamic strategy that repositions the portIolio
as external Iactors move the market Irom one state to the next. This Iactor analysis needs to be
a systematic process that generates consistent recommendations based on sound rational and
inIormed judgement. The aim is thus to create a process that it is more about optimal strategies
than optimal portIolios.
69
Part III
Review of EU pension frameworks
Chapter 6 The move to cross-border pension schemes
Institutions that provide occupational pension products were one oI the last to enjoy the
beneIits oI an Internal Market legislative Iramework. There has been a concerted move
however over recent years to introduce harmonised and advanced risk-oriented prudential
Irameworks in other parts oI the Iinancial sector; the most notable being the global Basle II
accord Ior credit institutions. Such supervisory Irameworks, incorporating the latest
developments in Iinance, actuarial science and risk management, intend to promote a level
playing Iield across countries. The road to harmony however is not such a smooth path; the
creation oI a pan-European pension Iramework is a large undertaking Ior EU legislators with
many competing constituencies and great potential Ior conIlicts oI interest. Change thereIore, is
best in an evolutionary Iorm.
Lewin`s force-field analysis for change
In order to address the mounting problem oI an ageing society, the European Parliament
realized that it would have to bring about change on a broad scale across the community. In
any situation that involves a degree oI upheaval there are always Iorces that support and resist
change. Lewin (1947)
1
developed the Iorce Iield analysis` as a Iramework Ior evaluating the
variables involved in planning and implementing a change program. To achieve change Lewin
argued that there is a need to address the status quo` or current stand-oII in a given system
through the introduction oI intervening variables in order to reposition both short-term and
long-term goals.
When applying the Iorce Iield analysis` Iramework to the European pension arena, it is
necessary to identiIy the opposing Iorces Ior change in the Iirst instance:
1. Driving forces for change in the pension industry
Forces that drive in the direction Ior change in the pension industry would include new
regulation, European directives, technology advancement, and developments in corporate
governance.
2. Restraining forces for change in the pension industry
Restraining Iorces are those that act to restrain or decrease the driving Iorces. In the pensions
industry they would include apathy, hostility, Member State social & labour laws, and existing
tax legislation.
1
Lewin, K. (Ed.). (1947). Force Field Analvsis and Diagram, Retrieved Irom
http://www.valuebasedmanagement.net/methodslewinIorceIieldanalysis.html
70
A situation oI Equilibrium is reached when the sum oI the driving Iorces equals the sum oI the
restraining Iorces as shown in Diagram 6.1 below.
Diagram 6.1: The force-fieId anaIysis
Forces for change Forces resisting change
Driving forces Restraining forces
This position oI equilibrium can be altered by changes in the relationship between the driving
and the restraining Iorces. Lewin argued that 'where there is equilibrium between the two sets
oI Iorces there will be no change, and thereIore in order Ior change to occur the driving Iorce
must exceed the restraining Iorce.
The Iirst stage in the process is to unIreeze` the situation by initiating some new measures oI
change. By introducing new regulation and issuing European directives on the harmonizing oI
pension systems across Europe the EC Parliament increased the driving Iorces Ior change.
However as a result oI such pressure, certain Member States entrenched themselves behind
their national social and labour laws which oIIer each country a certain degree oI protection
Irom Brussels; a new position oI equilibrium was thus created. The process oI overcoming
inertia had thereIore to be addressed once again through the introduction oI additional Iorces
Ior change or the elimination oI restraining Iorces in order to allay the Iears oI Member States.
This was achieved by the development oI a series oI open discussions across EC States inviting
Ieedback on all issues oI contention. The challenge Ior the EU was thereaIter to crystallize the
new mindset and reIreeze` the situation as the Iinal stage in the change process.
The primary aim oI such change is to deliver greater harmony in the pension systems across
Europe in order to promote occupational scheme development and the mobility oI labour.
Through the evaluation oI the balance oI power involved in the pension arena the EC
Parliament identiIied the key stakeholders and developed a strategy to inIluence the change
process. A sense oI urgency was created surrounding the problem oI an ageing population. A
series oI directives were issued in terms oI harmonizing legislation on pensions; these included
the IORP directive (2003)
1
and the Solvency II directive in (2005)
2
. The change was driven by
1
2
Commission oI the European Communities. (2007, July 10). Directive of the European Parliament and of the Council on the taking-up and
pursuit of the business of Insurance and Reinsurance- Solvencv II. Retrieved Irom The European Commission website:
71
CEIOPS, the European pension supervisors, which issued a protocol that provided Ior a
Iramework Ior the cooperation oI supervisory authorities. The directives clariIied how
inIormation would be shared among member states and outlined the required standards Ior best
practice in pension Iund management. The objective was to demonstrate how things would be
diIIerent Irom the past and how the provision oI healthy occupational schemes could be
structured Ior the Iuture.
72
Chapter 7 Institutions for Occupational Retirement Provisions (IORP)
With the onset oI globalization and the mobility oI labour playing an increasingly important
role in the employment oI personnel across Europe, it has become desirable to have an
occupational pension system that is acceptable across the borders oI EU Member States. On 11
May 1999, the European Commission announced the establishment oI The Institutions Ior
Occupational Retirement Provisions` or IORP, with a view to ensuring both the security and
the aIIordability oI pension schemes in Member States.
A} The a|ms and structure of an |0RP
An IORP is deIined in the Directive as an institution that operates separately Irom any
sponsoring undertaking Ior the purpose oI providing retirement beneIits in the context oI an
occupational activity. The IORP is used as a vehicle to receive contributions Irom a sponsoring
undertaking or employer with a view to Iunding their member`s pension liabilities.
The Directive on the activities and supervision oI IORP`s was published in the OIIicial EU
Journal on 23 September 2003 (IORP 2003)
1
. All member states were obliged to have
implemented the Directive by 23 September 2005. The Directive provides a regulatory and
supervisory Iramework Ior cross-border pension services. It acts as a Ioundation in the creation
oI a common market Ior the provision oI occupational pensions throughout the European
Union.
The Directive equips Iinancial services providers with their own set oI principle-based rules in
the domain oI occupational pensions. As oI 30 December 2005, the IORP Directive allows
institutions located in one EU member state to accept pension Iund contributions Irom
institutions in another EU member state. For a domestic pension scheme to engage in cross-
border activity, it must be authorized and approved by the national Pension Regulator`. To this
end the Directive argues Ior the minimization oI red tape when taking up cross-border activity
in order to ensure that an authorized IORP can automatically qualiIy Ior EIORP status.
The aims oI the Directive are to provide security to Iuture pensioners via a minimum common
standard oI governance, and to create a platIorm Ior a level-playing Iield in terms oI the sale oI
schemes across EU state borders. The Directive recognizes that Member States may wish to
impose diIIerent levels oI security on employer pension Iunds in accordance with their culture
oI risk. With this in mind, the Directive also grants Member States the right to decide upon
their level oI compliance, in accordance with the principle oI subsidiarity and to retain Iull
responsibility Ior the organisation oI their pension systems along with Iull responsibility Ior the
role and Iunctions oI the various institutions providing occupational retirement beneIits.
The Directive provides Ior an institution registered in one Member State as an IORP, to operate
in other EU member countries provided that it Iully respects the provisions oI the occupational
pension-related social and labour law` (SLL) in Iorce in the host Member State. This means
that the level oI technical provisions and security mechanisms relating to the host country
prudential Iramework must be applied to the IORP, even iI such requirements are not part oI its
home country legislation. The Directive is also clear on the issues oI pension Iund
commitments to their members, in that all liabilities should remain segmented in the diIIerent
countries where the pension sponsors provide their services.
1
73
A European passport has thus been established Ior institutions involved in the creation oI
employer-sponsored pension schemes, which allows them to oIIer their services on a European
scale. The IORP Directive Iocuses on the Iollowing three issues:
To ensure a high degree oI security oI pensions and oI protection oI the beneIiciaries,
through a qualitative approach combining a set oI basic prudential rules with qualitative
rules on pension Iund liabilities;
To make supplementary pensions more aIIordable by avoiding unduly restrictive
prudential rules Ior investment that would result in lower returns;
To allow pension Iunds to provide their services in another Member State, thereby
making it possible to have cross-border membership so as to reduce costs and to
encourage cross-border mobility within the Iirm.
A primary objective oI the IORP Directive is to secure closer co-operation between economic
policy makers and market Iorces in order to mitigate the levels oI risk and create greater
eIIiciency in the pension industry. The aim is to create a prudential Iramework Ior the
management oI pensions whilst at the same time liberating institutions in terms oI their
investment policy so that they may beneIit Irom the greater depth and liquidity oI the capital
markets. Merlin (2000)
1
argued that the ability oI pension Iunds to invest in equity and risk-
capital markets would result in a boost to the EU economy through the Iostering oI growth and
employment.
Occupational pension Iunds are one oI the largest institutional investors in Europe. Recent
estimates indicate that the total occupational pension Iund assets under management in the EU
are circa Euro 2 trillion in value; these assets are concentrated mainly in the UK, the
Netherlands, Germany and Spain. The total equity holdings oI the pension Iund portIolio stands
at just over Euro 1 trillion, representing on average 48 oI total assets. The total bond
portIolios holdings amount to Euro 688 billion or 32 oI total assets under management
(SteIIen 2008)
2
.
1. Pooling of assets and liabilities
For an IORP to realize its Iull potential it must be able to pool assets and liabilities, relating to
pension schemes across two or more Member States, into a single investment vehicle.
Ambrosius (2008)
3
outlined the Iollowing beneIits oI asset pooling as a result oI the IORP
Directive:
2. Quantitative benefits
Economies oI Scale;
Cost Savings;
Netting oI Cash Flows.
1
Merlin, M. (Ed.). (2000, October 23). INSTITUTIONS FOR OCCUPATIONAL RETIREMENT PROJISION. COMMISSION PROPOSES
DIRECTIJE. Retrieved Irom http://ec.europa.eu/market///mn16.htm
2
SteIIen, T. (2008, November 19). Check against deliverv. Speech presented at European Pension Funds Congress, FrankIurt.
3
Ambrosius, J. (2008, November 18). Asset Pooling for Pension Funds. Speech presented at European Pension Funds Congress, FrankIurt.
74
3. Qualitative benefits
Improved Investment DiversiIication;
Enhanced Investment Choice;
Access to Larger Universe oI Managers;
More Consistent Investment Approach;
Consolidated Reporting;
Higher Transparency;
Leaner and More EIIicient Administrative Processes.
It is the aim oI the IORP Directive to harmonize the occupational pension systems oI member
countries in terms oI the supply oI suitable Iinancial pension products. This in turn paves the
way Ior multinational Iirms to harmonize the investment side oI their pension business under a
single legal entity by choosing a site Ior their operations in a given EU-member country. By
Iacilitating this, the IORP Directive will potentially lead to signiIicant economies oI scale Ior
these institutions, thereby creating the conditions Ior managing occupational pension savings in
a cost eIIective manner.
4. Structure of a cross-border IORP
The diagram bellows illustrates how two or more local pension schemes can be integrated into
a centrally managed cross-border IORP. The diagram shows the structure oI an IORP under the
banner oI a single legal entity as opposed to plans that are either managed individually in each
country, or alternatively with the assets in a shared investment vehicle but with separate legal
entities.
Diagram 7.1: Structure of a cross-border IORP
Source: Mercer 2008
In the above model, a multinational company pension scheme is Iinancially regulated by the
'home country, which is in this case, Ireland. Each part oI the scheme representing members
located in either the Netherlands, Ireland or the UK, must comply with the tax, social and labor
laws oI that country, otherwise known as the "host" countries. The assets and liabilities
however are pooled at the home country level.
75
} Sovernance - The 6omm|ttee of European |nsurance and 0ccupat|ona| Pens|ons 8uperv|sors
(6E|0P8}
As an EU Iinancial services supervisory authority, CEIOPS is involved in the development oI a
cooperative Iramework between Member States to ensure that conditions emerge Ior
unproblematic cross-border activity in the occupational pensions sector. Supervisory co-
operation was agreed upon by all EU Member States with the Budapest Protocol, which
attempted to establish the rules and regulations under which pensions supervisors oI IORP`s
should operate. The general principles oI cooperation oI the relevant authorities were outlined
in terms oI what inIormation is required Irom either home or local regulators when authorities
Iind there is incompatibility between legal Irameworks where an IORP or sponsors want to get
approval to operate in a diIIerent state (CEIOPS 2009)
1
.
CEIOPS plays a signiIicant role in identiIying, and improving the transparency oI, national
SLL issues that aIIect the Iield oI pan-European occupational pension Iunds. To this end a
comparative assessment oI the Iinancial requirements Ior IORPs in the EEA countries was
conducted in March 08. The objective was to Iurther the development oI the European solvency
Iramework Ior IORPs by identiIying the range oI technical provisions and security mechanisms
in the European occupational pension sector (CEIOPS Mar 08). The report outlines the
diIIerences between the various local prudential regimes Ior IORPs and details the parameters
which are used Ior the actuarial calculations in each country.
The existing prudential Irameworks in the EEA are very diverse with diIIerences relating to
complex technical aspects and in part reIlect provisions in national SLL. Many Member States
are only now beginning to come to grips with the nature and operation oI their own systems in
relation to the IORP Directive. The creation oI a common, EU-wide Iramework is an additional
step Iurther, wherein it is necessary Ior Member States to understand each others` systems as
well as understanding the impact oI the IORP Directive. National SLL may determine the
content oI the pension promise, or may set minimum requirements, such as inIlation
protection, maximum discount rates, mortality assumptions, increase in premiums, reduction in
accrued rights, return guarantees, sponsor commitment and insolvency protection. These
requirements inIluence the level oI the technical provisions to be held by the IORP and the
Iunctioning oI security mechanisms (CEIOPS, Mar 08)
2
.
1. Regulatory abitrage
IORP`s may be tempted to use regulatory arbitrage in the selection oI their nominal home
country base, with a view to lowering the costs involved in complying with Iinancial
requirements. However there are many issues Ior employers or IORP`s to consider when
choosing where to base themselves in order to take advantage oI a multi-country IORP
platIorm. These include:
1
CEIOPS. (n.d.). (2009). Budapest Protocol (Consultation Paper No. 38). Retrieved Irom http://www.ceiops.eu//////CP-38-09-Budapest-
protocol.pdI
2
76
The availability oI good governance;
The ability to ring-Ience assets;
The extent oI solidarity permitted.
A careIul analysis oI the situation is required in order to successIully establish a cross-
border IORP; one which addresses all the Iacts and garners support Irom both the plan
sponsor and the members.
2. Funding rules for IORP`s
Adequate Iunding requirements and sound risk management practices are considered
essential to saIeguarding beneIiciaries` interests. In the case oI cross-border schemes, the
binding principle is Ior pension Iunds to be 'Iully-Iunded at all times and have an actuarial
valuation each year to make sure that remains the case. This target may not be viable in times
oI Iinancial crisis and therein presents an obstacle to the success oI the IORP Directive.
Although the Directive requires that IORP`s undertake a high level oI protection in terms oI
their commitments to member`s pensions, it is important that it also allows Ior temporary
underIunding should a suitable recovery plan be presented.
The Directive deIines the Iully Iunded status` oI schemes as being in possession oI suIIicient
and appropriate assets` to honour pension liabilities. The Iirst step in this process involves the
calculation by the pension plan administrator oI all projected payments to pensioners in Iuture
years. In order to be Iully Iunded, the plan must have enough capital contributions Irom the
plan sponsor, plus returns Irom investments, to pay those claims. Funding standards range Irom
speciIic quantitative rules with reserving, solvency buIIers and stress testing, to stating
precisely the liabilities to be covered on a principles based approach.
A Iurther qualiIication oI the concept oI mutual recognition` implies that, should a national
standard with regards Iunding rules be agreed upon in a given Member State, it must thereaIter
be accepted by other Member States without question. The EFRP (2005)
1
points out that
contradictions in the understanding oI the rules may occur wherein a home State grants
temporary underIunding to it`s domestic IORP`s and yet requires the Iully Iunded status` to
apply to the cross-border operations. This type oI anomaly would suggest that the techniques
Ior distinguishing domestic Irom cross-border operations need to be approached with particular
care.
Advanced Iunding may also be arranged by IORP`s whereby money is set aside separate Irom
any sponsor Ior payment oI the Iuture beneIits arising under the scheme. Whether Iunding is
provided by IORP`s or the schemes sponsor, there is concern that heavy Iunding
requirements may impose inappropriate large up-Iront payments that are not needed
because oI other security mechanisms already in place, thereby discouraging deIined
beneIit pension provision.
Keating (2009)
2
questioned iI the risk management interventions used by pension Iunds have
proven counter-productive in their application. Although pension contracts have long terms,
1
EFRP (Ed.). (n.d.). Annual Report 2005. Retrieved Irom http://www.eIrp.org//publications/20Annual20Report202005.pdI
2
Keating, C. (Ed.). (2009, November 2). 'Manv of our risk management interventions proved counter-productive in use`. Retrieved Irom
http://www.ipe.com//oI-our-risk-management-interventions-proved-counter-productive-in-use33153.php?articlepage1
77
risk management techniques operate on immediate, present values, and thus present a number
oI diIIiculties. Keating argues that: 'the long-term optimal strategy is only equal to the
progression oI optimal short-term strategies in extremely limited circumstances, which are most
unlikely to be satisIied in practice. One variant oI this arises Irom the European Pensions
Directive (IORP) which introduced a requirement Ior Iull Iunding at all times, notwithstanding
the reality that the only point in time at which this level oI Iunding is strictly necessary is when
the pension is due and payable. This requirement brings with it costs and consequences. In the
light oI the Iinancial crisis it may well be time to re-examine the basis Ior current pension
Iunding levels.
3. Particulars of the IORP
The IORP Directive does not apply to book reserve` pension systems wherein a reserve
is set up in the account oI the sponsor and a portion oI the company`s assets are
deemed to be set aside Ior the provision oI beneIits. Nor does it apply to pay-as-you-go
systems in which current beneIits are paid Irom current contributions into the system, with no
advanced Iunding as a rule. Additionally the IORP Directive does not apply to insurance-based
pension schemes wherein direct insurance arrangement premiums are paid to the insurer
and beneIits paid by the insurer to the beneIiciaries as they are deIined in the insurance
contract (CEIOPS 2008)
1
. To such arrangements the Third LiIe Directive (1992)
2
is applicable.
The IORP Directive is geared towards DB pension schemes, whether exclusively or in
combination with DC schemes. However, the Directive requirement Ior technical provisions
to be estimated and held does not apply to pure DC schemes.
4. EU - Social and labour law
Member States have identiIied Iour common principles that should underpin a pension
supervisory Iramework:
Risk-based approach to pension supervision individual countries tailor the scope
and intensity oI supervision to their appraisal oI risk Iaced by the IORP.
Market-consistency in the valuation oI an IORP`s assets and liabilities Ior supervisory
purposes in order to Iacilitate realistic solvency monitoring. This means that market
prices are used where available (mark-to-market), otherwise values may be
determined by a modelling approach (mark-to-model).
Transparency an IORP is open to scrutiny on all aspects oI how its Iinancial position
1
2
Third LiIe Directive, Third Council Directive 92//COUNCIL DIRECTIVE 92//EEC 1 (1992),
http://209.85.129.132/?qcache:oD6bkMWSIoMJ:www.sigortacilik.gov.tr/YD/ABD/.01-Hayat/.docCOUNCILDIRECTIVE92/
/EECoI10November1992&hlIr&ctclnk&cd1&glIr.
78
is determined.
Proportionality - supervisory requirements are applied in a manner proportionate to
the nature, complexity and scale oI the IORP`s inherent risks.
The deIinition and scope oI social and labor law is a matter oI concern Ior a number oI
Member States. Verhaegen in an interview with WoolIe Irom IPE (2009)
1
, argued that the
situation had become problematic in terms oI the boundary between home state prudential
protection and host state social and labour protection. She advocated that it was the role oI
CEIOPS to help solve problems associated with cross-border activity, such as those
involving diIIerent legal requirements and potential regulatory and or supervisory gaps and
overlaps.
5. Different types of IORP
With Member States using diIIerent valuation methods and diIIerent security mechanisms to
protect pension beneIits, the task oI ensuring a level playing Iield Ior cross-border IORPs
within Europe is diIIicult. Nevertheless the Directive stipulates that comparable pension
schemes need to be treated comparably across Member States.
There are two types oI distinguishable IORP`s in Europe:
The IORP is an independent legal entity, completely separate Irom the employer, with
Iull recourse to own Iunds. In this case the IORP would make a provision on its balance
sheet to cater Ior biometric risks or to guarantee a certain investment perIormance or
level oI beneIits. Although such a buIIer serves the role oI a shock absorber` in times
oI economic or cyclical crisis, it also carries the burden oI having to tie up capital in
order to IulIil a potential promise to the beneIiciary.
The IORP is set up by the sponsor who therein provides the ultimate pension security to
its employees. The Iuture and economic and Iinancial health oI both the IORP and
sponsor are thus inextricably linked.
It should be noted that there are various Iinancing systems and vehicles in relation to
occupational pension schemes across the EU. As a result, it is possible Ior more than one
system to exist in individual EU Member States.
} Techn|ca| prov|s|ons for |0RP's
IORPS operate as Iinancial institutions with a social purpose. To this end technical provisions
are required that give an indication oI the minimum amount oI assets that IORP`s should
possess in order to honour pension beneIits as and when they Iall due. There are many
variations in the methods and assumptions used by Member States to determine the level oI
technical provisions on issues such as inIlation/salary indexation, mortality assumptions, etc;
1
WoolIe, J. (2009, March 26). Quo vadis IORP? IPE.com. Retrieved Irom http://www.ipe.com//vadis-iorp31268.php?articlepage1
79
Assumptions Ior technical provisions are oIten based on best estimates with some countries
incorporating extra saIety margins and prudence in diIIerent components oI the technical
provisions. In particular a market-related discount rate` is employed by most countries to
calculate the present value oI Iuture pension payments. IORP`s recognise as a liability in the
balance sheet the present value oI current and Iuture pension rights oI all their members. In
many instances countries use current risk-Iree market rates to determine their discount rates.
Under the IORP Directive, all IORP`s must hold suIIicient assets to cover technical provisions
i.e. a minimum Iunding ratio oI 100. The Directive does allow Ior periods oI under Iunding
as long as the IORP has a concrete and realistic plan to ensure Iunding is restored. These
requirements derive Irom Articles 15 and 16 oI the Directive. This caveat does not exist
however in the case oI schemes operating cross-border, wherein the Directive requires Iull
Iunding oI technical provisions at all times (see IORP 2003, Article16)
1
.
EU Member States have leaned towards prudent valuation principles in terms oI the presence oI
extra reserves to compensate Ior additional security mechanisms. However such measures are
not easily quantiIiable and thus leave a degree oI uncertainty as to how large the reserves may
be. Table 7.1 below shows the range oI technical provisions provided by EU Member States
(CEIOPS 2008)
2
.
TabIe 7.1 Summary overview - Components of technicaI provisions
Source CEIOPS 2008
1
2
80
1. Inflation protection and salary indexation
The Iuture purchasing power oI pension beneIiciaries can be protected against the risk oI
inIlation through the indexation oI pension rights. In countries that commit to inIlation
protection and/or salary indexation, provision is made Irom IORP surpluses when available.
Some countries apply conditional inIlation indexation in that protection is granted only on the
provision that the IORP is judged to have suIIicient surpluses in excess oI the technical
provisions.
The CEIOPS paper reveals that iI the actual inIlation or wage growth exceeds the assumption
underlying the technical provisions, then a certain degree oI risk is leIt with the IORP. On the
other hand, should the guarantee be capped, some degree oI inIlation risk is leIt with the
member. This illustrates the need to set realistic inIlation assumptions and supports the
argument Ior an external benchmark such as the Consumer Price Index` to be used to calculate
the inIlation rate.
Table 7.2 shows in which EU countries an allowance Ior inIlation or salary increases must be
made in the technical provisions.
TabIe 7.2: AIIowing for infIation and saIary increases in the reserving method - Active members
Source: CEIOPS 2008
2. Interest rate used to discount the technical provisions
One oI the most important assumptions in calculating technical provisions is the
discount rate. From a market oriented perspective, the applied discount rate should correspond
to the security promised to the beneIiciary. The reason Ior this is that the mark-to-market
value oI a pension liability equals the market price oI the investment portIolio that
generates congruent cash Ilows. It Iollows thereIore that guaranteed pension liabilities should
be discounted at a risk-Iree rate (CEIOPS Mar 08)
1
. The CEIOPS survey shows that only Iour
countries apply the current risk-Iree market interest rate as the discount rate: The Netherlands,
Denmark, Sweden and Portugal. The objective is Ior the discount rate to be chosen prudently
and to take into account the yield oI the corresponding assets held by the institution along
with Iuture investment returns and/or the market yields oI high quality or government bonds.
1
81
Countries such as Spain and Austria use Iixed maximum discount rates set by the government
or the supervisor. Countries that select prudent discount rates below the current risk-Iree rate
will have an increased contribution to their technical provision levels. In countries where the
discount rate is above the current risk-Iree rate, the level oI technical provisions will be reduced
as less money is required to be put in reserve. In general the use oI Iixed discount rates makes
the technical provisions independent oI interest rate changes, i.e. the duration is zero. It should
be noted however that under mark-to-market valuation the duration oI pension liabilities is
substantial; oIten in the range oI 15 to 20 years.
A smaller group oI countries, including Germany, France and Norway, practice additional
prudence by setting a discount rate below the risk Iree market rate in accordance with Article
20 oI the insurance based Third LiIe Directive (1992)
1
. The discount rate does not exceed 60
oI the rate on bond issues by the State in whose currency the contract is denominated.
Fischer (2008)
2
observed that: 'in most countries, responses to emerging issues were measured
and contribute to scheme stability. Nevertheless one should analyse the signs oI stress and take
measures where appropriate. In my view some signs oI such stress indicate structural changes
Iunded pension schemes need to address. For example, given that variations in discount rates
have had such a strong impact on Iunding ratios, reIlects not only short term Iluctuation oI rates
but also the ever longer periods Ior which liabilities have to be calculated Iollowing continuous
increases in liIe expectancy oI members.
Diagram 7.2 shows the average discount rates as applied at the end oI 2006 as well as the 15
year risk Iree interest rates in each country.
Diagram 7.2: Discount rates (end 2006)
Source: CEIOPS 2008
1
http://209.85.129.132/?qcache:oD6bkMWSIoMJ:www.sigortacilik.gov.tr/YD/ABD/.01-Hayat/.docCOUNCILDIRECTIVE92/
/EECoI10November1992&hlIr&ctclnk&cd1&glIr.
2
82
3. Mortality assumptions
Technical provisions typically Iactor in the liIe expectancy oI scheme members, as set out in
mortality or liIe expectancy tables. Rates are determined by the domestic Iinancial services
industry oI each country in order to calculate scheme member survival probability and therein
biometric risk. The steady improvement oI liIe expectancies in Europe has resulted in many
countries taking the prudent step oI including a mortality trend in their table calculations.
Taking into consideration the observed trend in improving survival rates, rather then applying
current mortality rates, can have a considerable eIIect on technical provisions. The issue oI
longevity is coming to the Iore as Iund administrators oI DB schemes seek to address the
problems associated with meeting commitments to retired members over their liIetime.
4. Expenses
Reservation Ior Iuture expenses increases the size oI the technical provisions. An allowance oI
up to 5 in some cases is made by Member States Ior the Iuture expenses oI the IORP in terms
oI costs related to the administration, asset management and disbursement oI pension rights.
5. Security mechanisms
In accordance with the law oI each Member State, security mechanisms can be used to increase
the security oI the accrued and Iuture expected beneIits and reduce the chances oI any
shortIall in the Iunding level.
Lommen (2008)
1
observes that the Iinancing requirements Ior IORPs are not limited to
technical provisions, in that local prudential regimes also encompass a wide range oI
supplementary security mechanisms. All Member States are obliged to respect the IORP
Directive requirement oI Iully Iunded pension liabilities. Where the IORP underwrites the
liability and does not have sponsor support, it is required to hold additional Iunds in order to
mitigate the risk between the assets and the liabilities. The security mechanisms include:
Regulatory own Iunds and additional solvency buIIers;
Subordinated loans;
Sponsor commitment and increases to contractual premiums/sponsor
contributions;
Guarantee Iunds;
Mechanisms to reduce accrued pension rights;
Reduction oI Iuture conditional inIlation.
Table 7.3 distinguishes between countries that impose mandatory solvency buIIers on the IORP
sponsor and those that do not. These can be sub-divided into ex ante and ex post security
mechanisms.
1
Lommen, J. (Ed.). (2008). IORP II. towards a new solvencv framework? Retrieved Irom
http://www.ipe.com//IItowardsanewsolvencyIramework28781.php?articlepage1
83
6. Ex ante security mechanisms - regulatory own funds` and subordinated loans`
Ex ante security mechanisms are Iinanced in advance by IORP`s and kept separate Irom
the sponsoring company. The CEIOPS report identiIies the Netherlands, Belgium,
Germany, France and most Scandinavian countries as territories that incorporate
saIeguards in the Iorm oI regulatory own Iunds`. This buIIer acts as a security mechanism
by ensuring that the pension promise can be honoured in times oI Iinancial distress. These
additional assets are oIten used by the IORP to cover against biometric risks, or
alternatively to guarantee a given investment perIormance or level oI beneIits.
Pichardo-Allison (2009)
1
provides an example oI the use oI such security mechanisms in
Sweden, where a series oI buIIers named AP Iunds where set up at the turn oI the
millenium to protect public company pensions. The pension system is set up as a PAYG
structure with incoming contributions used to pay the beneIits oI current retirees, whilst
the AP Iunds are used as buIIers to cover Iuture contributions.
A number oI Member States allow IORP`s to partially Iinance solvency buIIers via
subordinated loans` which are in turn Iacilitated through recovery periods. A subordinated
loan is ranked behind the rights oI members and beneIiciaries in terms oI the legal
obligations oI repayment. The liability oI such loans may be written to another party other than
the sponsoring company e.g. an insurance company, and thus oIIer unlimited loss absorption in
case oI an insolvency situation as all payments on the loan are subordinated to all
pension liabilities. In countries where the IORP does not itselI bear biometric risks, but where
the IORP has Iull recourse to the sponsor, such buIIers are not required.
TabIe 7.3 Summary overview of security mechanisms
Source: CEIOPS 2008
7. Ex post security mechanisms - sponsor commitment` and guarantee funds`
In some countries ex post security mechanisms are in place in the event oI an IORP being Iaced
1
Pichardo-Allison, R. (2009, April 15). Swedish AP system put to the test. Global Pensions. Retrieved Irom
http://globalpensions.com/.html?pagegpdisplaynews&tempPageId852657
84
with an underIunding crisis. Countries with such buIIers include the UK, Ireland, Germany,
Belgium and Luxembourg. In this group the sponsoring undertaking is the driving Iorce behind
the provision oI beneIits Ior the employees and thereIore plays a key role in the Iunding oI the
IORP. The role played by the sponsor in relation to the pension commitment will depend
largely on the nature oI the promise in the context oI the national legislation oI the country in
question.
In some countries, payment oI Iuture contributions by the sponsor may be adjusted upwards to
eliminate under Iunding, whereas in others contribution levels can be renegotiated by the
parties involved with a view to generating a recovery plan to cover shortIalls in Iunding.
However, schemes operating cross-border are obliged to be Iully Iunded` at all times. The
actual length oI the recovery period Ior all countries depends on the IORP`s individual
circumstances and risk proIile.
A number oI Member States, including the UK, use guarantee Iunds` as a security
mechanism in the event oI the sponsor or the IORP becoming insolvent. This acts as a levy
on the sector to cover insurance providers against the risk that they will have to bail out
sponsors in the Iuture. Contributions to the guarantee Iund are made by both national
governments and Iees Irom IORP`s and their sponsors. The Iund is designed to act as a
mechanism oI last resort` in the event oI there being no Iurther recourse to a sponsor, or iI
the assets oI the IORP are insuIIicient to pay out the beneIits due. Pension guarantee
schemes help to maintain solvency levels and therein the security oI member`s retirement
plans. Such Iunds however run the risk oI creating moral hazard` Ior the pensions industry
in that they act as a saIety net Ior the poor risk management or governance oI Iunds.
8. Reduction of accrued pension rights and non-mandatory increases
In extenuating circumstances, renegotiation with the IORP, unions, and sponsors may include a
reduction oI accrued pension rights in order to restore a situation oI under Iunding. A situation
such as this would arise as a result oI Iailed risk management or supervision and would be
exercised with a view to saving the IORP Irom insolvency.
CEIOPS (2008)
1
reports that in countries where Iuture indexation is conditional and
thereIore not explicitly reserved Ior, indexation may be granted on a year-by-year basis
depending on the IORPs` current Iinancial position and prospects thereoI. Reduction oI
these non-mandatory increases can in some countries serve as a security mechanism. By not
Iully granting indexation, the IORP reduces the chance oI insolvency; the money that would
otherwise have been applied to indexation is thus used to strengthen the Iunding ratio as part oI
a broad recovery plan.
1
85
} The need for assessment
Lommen (2008)
1
comments that comparing the prudential regimes oI IORPs in diIIerent
European countries is like comparing apples with pears in that a Iramework or benchmark Ior
the assessment oI the combined eIIectiveness oI all individual mechanisms is currently lacking.
In Belgium past cases oI insolvency were usually resolved by means oI additional
sponsor contributions. In Germany, a combination oI available capital, increased contributions
and beneIit reduction was used to tackle the problems arising Irom the Iinancial crisis in the
beginning oI this century. In The Netherlands a combination oI high solvency buIIers,
increased contributions, reduction oI indexation and the use oI subordinated loans successIully
absorbed these problems.
CEIOPS highlights that technical provisions and supplementary security mechanisms
Irequently counterbalance each other. In countries where technical provisions are set
prudently, the need to Iinance supplementary security mechanisms is oIten minimised.
Elsewhere, the opposite is true. It is also important to consider the accountancy standards
applicable to IORPs and sponsors when determining solvency rules that protect the security
oI schemes.
Instruments providing ex post security such as sponsor contributions are usually needed in
times oI economic downturn, however such Iinancial obligations may threaten the economic
health oI the sponsor and therein present itselI as a credit risk to the individual member. This
impact can be mitigated by the existence oI additional Iunds or assets as collateral on
which a claim may be made by the IORP and also by allowing a longer recovery
period that spreads out the eIIects oI adjustment measures over the cycle.
1. Ranking
In order to prevent insolvency or to recover Irom actual insolvency, security
mechanisms may operate simultaneously or sequentially; in the latter case, one security
mechanism takes over when the previous one is exhausted (CEIPOS 2008)
2
. Mechanisms, such
as solvency buIIers, subordinated loans or a guarantee Iund, are capitalised, which means that
security is arranged up-Iront. Those against the use oI capitalized security Ior covering risk
would argue that this approach ties ups capital ineIIiciently and increases the upIront cost to
employers and hence may interIere in the balance between cost and pension provision
where employer sponsorship is entirely voluntary.
CEIOPS commented on the impact oI the Iinancial turmoil on IORP`s as institutional investors
in its Spring Financial Stability Report (2009)
3
with speciIic reIerence to the Iinancial
1
http://www.ipe.com//IItowardsanewsolvencyIramework28781.php?articlepage1
2
3
CEIOPS. (2009, June). Spring Financial Stabilitv Report. Retrieved Irom http://www.ceiops.eu/////Spring-Financial-Stability-Report-
2009.pdI
86
conditions and Iinancial stability oI the insurance and occupational Iund sector in the EU/EEA.
The report noted that although IORPs had suIIered as a result oI sharp drops in equity markets,
the impact "had not been as severe as seen in other Iinancial sectors as the long-term nature oI
the liabilities aIIords some protection in this respect and IORPs have not experienced the
liquidity problems experienced elsewhere". However, CEIOPS did recognize that the DB
occupational pension Iund sector is under increased pressure because oI low interest rates and
prevailing longevity risk. The report revealed that the Iinancial crisis had taken its toll on the
Iunding levels Ior DB schemes across Europe with countries such as the Netherlands and the
UK reporting Iunding levels oI less than100.
CEIOPS counselled that: "it is essential that IORPs do not over-react in the Iace oI the
downturn; moreover they should ensure that they are active and alert to potential changes in
the Iunding level oI the IORP and also the health oI the sponsor". It noted that closer
scrutiny by supervisors was becoming more oI a common Ieature, and added that "the
current regime is seen by many as being Ilexible enough to cope".
2. The development of IORP`s in Europe
A key concern oI IORP critics is on the issue oI whether they are the most eIIective and cost
eIIicient vehicles Ior the provision oI occupational pensions. On the one hand there is the
prevailing argument that the strict regulatory regime governing IORP`s results in capital
being tied up unnecessarily that could otherwise be invested in the marketplace; supporters
oI IORP`s however would propose that the same strict governance structures could help
develop adequate and low-cost workplace pension provision that avoid incentives Ior
excessive risk-taking in managing investments.
CEIOPS has taken an active role in identiIying those European pension schemes which are
not currently covered by any European Union legislation, as part oI its continuing review oI
cross-border pension supervision. Henderson (2009)
1
reports that in a recent study
conducted by CEIOPS between June 2008 and June 2009, it was revealed that 10 new cross-
border IORPs had been created, thus bringing the total number oI IORPs in existence to 80.
Ireland, Liechtenstein, Luxembourg and the UK all reported new IORP activity over the
year, while Finland and Portugal announced that activity had ceased. Hungary and Romania
became two new European countries presenting their territories as host states Ior IORP`s,
whereas Slovenia removed itselI as a host territory.
The total IORP Iigure was however reduced to 76 when the regulatory authorities oI Austria,
Finland, Luxembourg and Portugal announced that they had experienced IORP withdrawals
during the same period. The Iour withdrawals suggested that there are ongoing disputes over
what exactly constitutes the technical provisions Ior employers that wish to put in place cross
border schemes. OI greater signiIicance, was the revelation by CEIOPS in the report that
there was evidence oI a clear trend developing in the most recently established IORP`s Ior DC
based arrangements with up to 350 members.
1
Henderson, J. (Ed.). (2009, November 9). Slow IORP growth highlights cross-border complexitv. Retrieved Irom http://www.ipe.com//iorp-
growth-highlights-cross-border-complexity33215.php
87
Chapter 8 Occupational pensions and the Solvency II draft Directive
Both occupational pension Iunds and liIe insurers IulIil the role oI pension providers across the
EU. A broad spectrum oI pension Iund arrangements now exists with pension Iunds in several
Member States oIIering the same products as insurance companies.
In competition with the IORP Directive is the European Union Solvency II Directive with its
Iocus on risk based Iunding requirements Ior insurance companies. The DraIt Directive covers
the EEA including Norway, Lichtenstein and Iceland, as well as the 27 countries oI the
European Union. The Solvency II project aims to establish a single set oI rules governing
insurer creditworthiness and risk management. These rules will include public risk disclosure
with a view to increasing risk transparency and enIorcing market discipline on undertakings. As
a result oI transparency, the insurance industry will be able to provide greater consumer
conIidence, thus enabling stakeholders to make comparisons as to which undertakings oIIer the
most cost-eIIective protection and the more innovative and competitive products.
A} The 8o|vency || 0|rect|ve
Solvency capital requirements Ior EU insurers have been in place since the 1970s. Following a
review required by the third generation Insurance Directives oI the 1990s, limited reIorms
known as Solvency I, were agreed by the European Parliament and the European Council in
2002.
The Solvency II Directive was published on the 10th July 2007; it merges together a number oI
existing directives covering insurance and re-insurance, and incorporates changes to upgrade
the prudential supervision oI insurance. The key aims oI the Directive are to:
Deepen the integration oI the EU insurance market;
Enhance the protection oI policyholders and beneIiciaries;
Ensure that that the quantitative Iunding requirements better reIlect the true risk oI an
insurance undertaking;
Improve the international competitiveness oI EU insurers and reinsurers;
Promote better regulation;
Overcome inadequacies oI the Solvency I Directive.
1. Success factors in the insurance industry
The key to a healthy insurance industry is not solely about the technical calculation oI capital
reserves, but moreover about the approach to enterprise risk management (ERM). Under
Solvency II insurers are thus obliged to install improved governance and risk management
Iunctions and policies in order to maintain an adequate solvency position. A Iurther aim oI
Solvency II is to coerce Iinancial Iirms into retaining large capital buIIers that will oIIer
protection Irom any Iuture credit squeeze. Success will be achieved by:
Harmonising Solvency II rules across Member States;
Aligning capital requirements to each company`s risk proIile;
Emphasis on ERM;
Establishing an integrated risk-based approach to supervision.
88
2. Key features
Solvency II is committed to a market consistent approach Ior the valuation oI assets, liabilities
and capital requirements. The Directive stipulates that solvency capital calculations, whether
based on an industry standard Iormula or an internal model, should be aligned to the individual
risk proIile oI the undertaking. The standard Iormula categorises risks into modules Ior capital
purposes with an allowance Ior aggregation and diversiIication across the modules. An internal
model would thus reIlect a Iirm`s speciIic risk proIile and management approach more
precisely.
3. Timeline
The draIt Directive was conceived in 2005 and is due to be implemented by Member States in
2012. Below is a timeline Ior the implementation process:
Diagram 8.1: SoIvency II timeIine
Source: EMB 2008
4. The regulatory framework - 3 Pillars
The Directive aligns the risk quantiIication and management oI insurance groups with a
Iramework Ior supervisory review and public disclosure. The objective is to provide the
industry with the necessary regulations and tools to protect pension Iund members. Solvency II
thus oIIers a complementary 3 pillar approach to saIeguard against risk. These pillars are not to
be conIused with the three-pillar variant oI EU national pension structures as outlined by the
World Bank in 1998 and covered in Chapter 1.
Diagram 8.2: Three piIIar approach to safeguard insurance-based pension schemes against risk
Source: EMB 2008
89
Diagram 8.2 displays the required structure Ior an integrated risk and capital management
Iramework under the Solvency II Directive (EMB 2009)
1
. The pillars` objectives are as
Iollows:
Pillar 1
Sets minimum capital requirements;
Requires each Iirm to calculate its capital requirement using either a standard Iormula
or an internal model.
Pillar 1 involves a quantitative assessment oI risk, applying an economic risk-based approach
wherein all risks are explicitly allowed Ior. The aim is to Iacilitate the early detection oI new
and emerging risks and thereIore create greater scope Ior preventative action to be taken.
Pillar 2
Requires each Iirm to assess and manage the risks to which they are exposed and to
maintain adequate capital levels;
The Iirm's assessment oI its capital needs and oI its risks are subject to supervisory
review.
Pillar 2 takes a qualitative approach to risk assessment in terms oI internal risk management
processes and controls.
Pillar 3
Requires regulated Iirms to disclose key inIormation in their Iinancial reports;
Aims to enhance market discipline on the regulated Iirm.
Pillar 3 Iocuses on the issue oI transparency using supervisory regulation and public disclosure
requirements to encourage best practice.
B) Governance of insurance-based pension schemes
Plantin, and Rochet (2007)
2
in their study oI the prudential regulation oI the insurance industry
recognized that the cause oI Iailure Ior a number oI EU insurers was linked to poor internal
controls and risk-management processes rather than inadequate capitalisation per se. They
argued that the key issue that needed to be addressed by the insurance sector was one oI
corporate governance.
1
EMB Worlwide. (n.d.).(2009). Solvencv II - Understanding the Directive |Brochure|. Retrieved Irom
http://www.emb.com/////20II20BrochureFINAL-low20res.pdI
2
Plantin, G., & Rochet, J.-C. (2007). When insurers go bust. An economic analvsis of the role and design of prudential regulation. Princeton:
University Press.
90
A primary objective oI Solvency II was to cover any blind spots` in previous insurance
industry legislation by requiring Iirms to meet regulatory principles rather than rules. The
proposed regime acknowledges that some types oI risk are best addressed through good
governance rather than by simply allocating additional solvency capital. To this end the
directive introduces a set oI qualitative requirements to control investment management in the
Iorm oI the prudent person` approach.
However, the Directive purports that the onus should be on the Iirm to demonstrate that its
governance and risk management policies are both sound and appropriate Ior its speciIic risk
proIile. To this end the supervisor requires that undertakings provide documentation oI:
policies and procedures;
roles and responsibilities;
reporting and Management InIormation (MI).
In terms oI ERM, Solvency II stipulates that the risk management Iunction should be conducted
on a continuous basis in the Iirm and include strategies, processes and reporting procedures that
cover the Iollowing:
underwriting and reserving;
asset - liability management;
investment, in particular derivatives and similar commitments;
liquidity and concentration risk management;
reinsurance and other risk mitigation techniques.
As an alternative to applying a standard Iormula Ior the calculation oI its solvency capital
requirements, insurance groups may use an internal model, provided that they can demonstrate
to the supervisor that the necessary solvency precautions have been embedded in the risk
management system. Additional responsibilities in relation to the use oI an internal model
would include documentation on the Iollowing:
design and implementation;
testing and validation;
documentation including maintenance;
analysis and reporting on its perIormance;
model improvement and enhancement.
1. Supervisory review process (SRP)
It is the job oI the supervisor to review and evaluate the compliance oI the Iirm in terms oI risk
management procedures in relation to its operating environment. The task oI an SRP is to
measure the capability oI the Iirm`s governance system in identiIying, assessing and managing
the risks and potential risks it Iaces as a business and to gauge the ability oI the company to
absorb adverse conditions in the event oI a downturn in the economy. The supervisor has the
power to Iorce Iirms to remedy any apparent weaknesses and deIiciencies in the ERM system,
including strategies, processes and reporting procedures, so as to increase conIidence in the
overall solvency position.
91
The review will consider:
the system oI governance and risk assessment;
the technical provisions;
the capital requirements;
the investment rules;
the quality and quantity oI own Iunds;
the use oI a Iull or partial internal model, iI deployed.
In certain circumstance the SRP may impose a capital add-on iI the supervisor is oI the opinion
that the risk proIile oI the Iirm deviates signiIicantly Irom the assumptions underlying the
solvency capital calculation, or alternatively that there are concerns regarding the governance
standards within the Iirm. The supervisor may also request that the Iirm develop a Iull or partial
internal model iI it transpires that the standard Iormula does not accurately capture their
speciIic risk proIile.
2. Report on solvency and financial position
In accordance with the principle oI proportionality, the scope and level oI detail in public risk
disclosure should depend on the nature, scale and complexity oI the undertaking`s business.
The ChieI Risk OIIicer Forum (CRO Forum)
1
in November 2008 recommended Iive key
principles Ior risk disclosure:
Adopting the consolidated group position as the reIerence Ior public risk disclosure.
The choice between group or entity disclosure should be based on where the risks are
principally managed and overseen; group-level disclosures should thereIore be required
Ior governance as well as Ior risk and capital inIormation.
The disclosure should seek to leverage the undertaking`s existing and Iuture
International Financial Reporting Standards (IFRS) annual reporting requirements and
timing as Iar as possible.
Risks that are material should be publicly disclosed. A risk is considered material iI its
omission or misstatement could inIluence the economic decisions oI users taken on the
basis oI the public disclosure, or iI the undertaking considers them large enough to
threaten its operations.
The disclosure should be relevant and appropriate to both the risks involved and the
needs oI the relevant audience (i.e. inIormed knowledgeable users`).
For the purposes oI comparison between undertakings, capital requirements should be
disclosed at the conIidence level and holding period assumed in the Solvency II
standard Iormula (using the standard model or an equivalently calibrated internal
model).
1
CRO Forum (Ed.). (2008, November). Public risk disclosure under Solvencv II. Retrieved Irom http://www.croIorum.org/publications.ecp
92
6} R|sk management funct|on of |nsurance-based pens|on schemes
The risk management Iunction is responsible Ior the control oI risks across the organization and
is divided into risk categories, with dedicated departments Ior non-liIe underwriting risk, liIe
and health underwriting risk, market risk, credit risk and operational risk. At the business level,
risk managers oI each oI these departments identiIy, assess and manage Iinancial and non-
Iinancial risks, and report to the local Risk Director who in turn reports to the ChieI Risk
OIIicer. None oI these departments is actually involved in the execution oI business. Instead,
they independently oversee risk-taking activities, and set the risk management guidelines and
best practice standards that the business units implement (CRO Forum, Nov 2008)
1
.
The Solvency II Directive requires undertakings to produce a report on their solvency and
Iinancial position which includes the Iollowing:
1. A risk overview and governance framework
This risk overview and governance Iramework outlines the control procedures and monitoring
systems involved in the risk management decisions oI the undertaking. These will include a
description oI roles and responsibilities oI Board oI Directors and risk management committee
members with a view to ensuring that the holders oI key risk management positions are Iit and
proper persons in accordance with the required criteria. The CRO Forum recognizes that the
Iramework will also include inIormation on outsourcing agreements which transIer key risk
management Iunctions and related activities to external parties outside the undertaking and its
subsidiaries.
The primary objective oI the risk management process is to limit the impact oI adverse events,
while ensuring an eIIicient use oI capital to support business activities and create value. The
risk control Iramework is thus responsible Ior the protection oI the Iinancial strength oI the
undertaking, protection oI reputation, risk transparency, management accountability and
independent oversight.
The overview will require descriptions oI the Iollowing:
Risk policy and control Iramework;
Risk reporting activities and who is the target audience;
List oI material risk` areas that the undertaking is exposed to and the classiIication oI
material risk areas in terms oI being assessed quantitatively or qualitatively;
Risk and solvency assessment either using the standard model` speciIied by Solvency
II regulation or alternatively a description oI the internal model` providing inIormation
with regards the main diIIerences between the standard Iormula and the internal model
used by the undertaking Ior the calculation oI its Solvency Capital Requirement (SCR);
Description oI risk mitigation activities (incl. reinsurance, Iinancial market
instruments).
1
CRO Forum (Ed.). (2008, November). Public risk disclosure under Solvencv II. Retrieved Irom http://www.croIorum.org/publications.ecp
93
2. Risk assessment by risk category
An assessment oI material risks is made by the businesses, and challenged, reviewed and
aggregated at group level by the Group`s risk department. This process would include both
quantitative and qualitative assessed risks in terms oI required risk capital. It is necessary to
have an outline oI policies, processes and standards in place to manage the Iollowing:
Non-liIe underwriting risk;
LiIe and health underwriting risk;
LiIe and health underwriting risk;
Market risk;
Credit risk;
Operational risk.
a) Non-life underwriting risk
Non-liIe underwriting risk is the risk arising Irom the underwriting oI non-liIe insurance
contracts. It includes the risk oI loss or oI adverse change in the value oI insurance liabilities
resulting Irom non-liIe premium and reserve risk, as well as non-liIe catastrophe risk.
b) Life and health underwriting risk
LiIe and health underwriting risk is the risk arising Irom the underwriting oI liIe and health
insurance contracts. It includes the risk oI loss or oI adverse change in the value oI insurance
liabilities resulting Irom mortality risk, longevity risk, disability and morbidity risk, liIe
expense risk, revision risk, lapse risk, liIe catastrophe risk, health expense risk, health premium
and reserve risk, and health epidemic risk.
c) Market risk
Market risk is the risk oI loss or adverse changes in the Iinancial situation, caused by
Iluctuations in the level and the volatility oI the market prices oI assets, liabilities and Iinancial
instruments. This comprises interest rate risk, equity risk, real estate risk, currency risk, credit
spread risk. Market risk arises Irom three main sources: the Group`s investment activities, the
Iinancial market sensitivity oI the economic value oI liabilities, and the capital markets trading
activities.
Stress tests should be used to estimate the potential loss oI the investment portIolio under
extreme market conditions. These would be conducted using parameters such as an estimated
20 Iall in equity, real estate and hedge Iunds, or alternatively an interest rate rise oI 100bp in
all currencies, in order to Iorecast the impact oI rare occurrences on the economic balance
sheet.
d) Credit risk
Credit risk is the risk oI loss or adverse change in the Iinancial situation, resulting Irom
Iluctuations in the credit standing oI issuers oI securities, counterparties and debtors to which
the undertaking is exposed. The credit standing oI insurers is reIlected in the ratings oI the
bonds that they hold in their portIolio. Meanwhile, credit risk exposure arises Irom Iinancial
transactions with asset issuers, debtors, intermediaries, policyholders or reinsurers; it is
comprised oI credit deIault risk and credit migration risk.
94
e) Operational risk
Operational risk is the risk oI loss Irom inadequate or Iailed internal processes, Irom personnel
and systems, or Irom external events including legal risk.
It is important that risks are assessed qualitatively along with an examination oI the policies,
processes and standards that are in place to manage the Iollowing:
Liquidity risk;
Strategic risk;
Reputational risk.
f) Liquidity risk
Liquidity risk is the risk that the company does not have suIIicient Iunding available to meet its
Iinancial obligations when they Iall due or the risk oI not being able to borrow Iunds in the
market at an acceptable price to Iund its commitments.
g) Strategic risk
Strategic risk is the risk oI any current or prospective impact on earnings, or capital arising
Irom adverse business decisions. Strategic risk can also be as a result oI the improper
implementation oI decisions or lack oI responsiveness to industry changes.
h) Reputational risk
Reputational risk is the risk oI potential damage to the organization Irom the deterioration oI its
reputation or standing due to a negative perception oI its image among customers,
counterparties, shareholders or regulatory authorities.
0} R|sk m|t|gat|ng act|v|t|es
An undertaking would mitigate part oI its risks in order to limit catastrophe exposure and
reduce the impact oI a potential reduction in asset values or a potential increase in liability
values caused by unIavourable market movements. Reinsurance would be used to protect
against catastrophic claims, to diversiIy risk, to stabilise Iinancial ratios and to obtain additional
underwriting capacity. In addition, capital market instruments may be used to protect against
insurance and Iinancial market losses.
Capital adequacy management
As part oI the new culture oI transparency, insurance groups are required to disclose their
objectives, policies and processes Ior managing the capital and/or solvency position. An
undertaking should develop a policy oI maintaining a strong capital base in order to support the
development oI its business and to be adequately capitalised at all times. The onus is on the
operation to have such measures in place even Iollowing a signiIicant adverse event. The
requirement includes submission oI both qualitative and quantitative inIormation on the
undertakings position with regards:
Internal capital adequacy;
Regulatory solvency issues.
95
The internal risk capital model plays a signiIicant role in solvency management and capital
allocation. The Solvency II Directive requires that an undertaking should develop models such
as the value-based approach` to measure and manage its business activities and to optimise
capital allocation. The internal available capital may be based on published shareholders`
equity adjusted to reIlect the Iull economic capital base available to absorb any unexpected
volatility in results oI operations. This shareholders` equity Iigure may include the present
value oI Iuture proIits in the liIe assurance and pensions segment.
96
Chapter 9 Solvency II and quantitative funding requirements
'You onlv learn who has been swimming naked when the tide goes out` (Warren Buffett 2009)
The Solvency II Directive outlined a series oI quantitative yardsticks Ior the calculation oI
Iunding requirements Ior insurance operations. In order to evaluate the impact oI these Iunding
requirements, a number oI Quantitative Impact Studies (QIS) were perIormed by CEIOPS in
2007 called the QIS 3 Iramework
1
, which summarized the current status oI the standard model
Ior insurance companies.
0|8 3 framework
The QIS 3 model consists oI two building blocks:
A market consistent valuation oI pension liabilities, reIerred to as Technical
provisions`;
Calculation oI the Solvency Capital Requirement (SCR).
Diagram 9.1: Overview of QIS 3 modeI
Source: CEIOPS 2007
1. Technical provisions (TP)
The QIS 3 model highlighted above requires a market consistent valuation oI assets and
liabilities using a total balance sheet approach. In terms oI assets, market values are normally
ascertained using a mark-to-market` approach at a given point in time, or alternatively can be
calculated on a mark-to-model` basis wherein values are based on internal assumptions or
Iinancial models. However, as pension liabilities are non-hedgeable due to the nature oI
embedded longevity risk, it is invariably diIIicult to value them. The valuation oI pension
liabilities is thus split into two parts, the best estimate oI liabilities` (BEL) and the risk
1
CEIOPS (Ed.). (2007). QIS Technical Specifications Part I Instructions. Retrieved Irom
http://www.ceiops.eu//////TechnicalSpeciIicationsPart1.PDF
97
margin`.
CEIOPS (2007)
1
calculated the BEL as being equal to the expected present value oI all
potential cash Ilows arising Irom the pension promises calculated according to the Iollowing
principles:
Valuation based on already accrued beneIits;
Realistic assumptions including Iuture expenses;
Risk Iree discounting based on the swap curve`;
Allowance Ior market value oI options and guarantees; the BEL has to include both
guaranteed beneIits and extra beneIits such as Iuture conditional indexation.
The technical provisions must also include a risk margin that meets the objectives either to
transIer the portIolio to a third party, or to recapitalize the pension Iund to ensure a proper run-
oII by the original undertaking. Underlying assumptions can be summarized as Iollows:
Assume that the pension Iund becomes insolvent at the end oI the Iirst year due to
economic loss and that the portIolio oI assets and liabilities is taken over by another
pension Iund (the reIerence pension Iund).
The reIerence pension Iund has to be compensated Ior additional SCR that it has to put
up during the whole run-oII oI the portIolio.
Assume that the reIerence pension Iund would eliminate investment risk (resulting in
zero SCR Ior market risks Irom year 2 onwards; only liIe underwriting and operational
risk remain).
The risk margin is equal to the present value oI the cost oI Iuture SCR that the reIerence
pension Iund will have to put up during the run-oII oI the portIolio oI assets and liabilities Ior
the in-Iorce book oI business at the end oI next year (t1).
The TP equals the sum oI BEL and the risk margin. The diIIerence between the market value oI
the assets and the TP gives the available capital` that can be used to absorb risks.
Although the QIS 3 Iramework was initially designed Ior (liIe) insurance companies, the model
can be extended in order to better reIlect the speciIics oI pension Iunds. A study was conducted
by Peek et al (2008)
2
on the evaluation oI the impact oI risk based Iunding requirements on
pension Iunds. This was conducted by perIorming quantitative analyses oI Iunding
requirements based on the Solvency II (QIS 3 methodology) risk based valuation Iramework.
The results suggested that as the underlying principles Ior risk based Iunding requirements are
similar Ior both the IORP and Solvency II approaches to pension management, that there may
well be scope to modiIy the QIS 3 in order to create a more level playing Iield` Ior the
pensions industry as a whole.
1
2
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2. Solvency II and regulatory capital requirements
The European Commission adopted the Solvency II proposal as a more risk oriented instrument
in 2005. The model was reviewed in July 2007 and an amended proposal issued on 26 February
2008. The Solvency II Framework Directive proposes two regulatory capital requirements, the
solvency capital requirement (SCR) and the minimum capital requirement (MCR).
a) Solvency Capital Requirement (SCR)
The Solvency Capital Requirement (SCR) has been established as the new standard Ior
insurance-related operations to calculate their solvency positions annually. Available solvency
capital is deIined as the market value oI the assets minus market value oI the liabilities. The
undertaking`s SCR must thus be covered by an equivalent amount oI assets in excess oI
liabilities. II the SCR is not covered then the Iirm must submit a recovery plan to the supervisor
and will be closely monitored to ensure compliance with this plan.
The SCR is calculated in one oI two ways:
use oI the standard Iormula;
use oI an internal or partial internal model.
The standard SCR Iormula is a risk-sensitive consideration oI all aspects oI the Iirms` business,
including the duration oI liabilities, the assets held, and any operational risk.
The SCR calculation is based on the Iollowing principles11:
The SCR should deliver a level oI capital that enables an insurance undertaking to
absorb signiIicant unIoreseen losses and gives reasonable assurance to policyholders
(plan members) that payments will be made as they Iall due;
It should reIlect the amount oI capital required to meet all obligations over a speciIied
time horizon (1 year) to a deIined conIidence level (99.5);
In doing so, the SCR should limit the risk that the level oI available capital deteriorates
to an unacceptable level at any time during the speciIied time horizon.
The SCR should take into account all signiIicant, quantiIiable risks (including market
risks, liIe underwriting risks and operational risk).
In the QIS 3 Iramework, capital requirements are Iirst calculated separately Ior each individual
type oI risk assuming a worst-case change in the underlying risk Iactor e.g. a signiIicant drop oI
over 25 in the index Ior global equity investments. The capital requirements Ior the diIIerent
risk Iactors are then aggregated using predeIined correlation matrices employing a variance-
covariance approach.
b) Internal models for solvency capital requirements
Subject to approval by the supervisor, a Iirm may replace the standard Iormula SCR parameters
by an internal model. The internal model allows a much more bespoke risk assessment oI a
particular business, and has the potential to be a useIul management tool.
99
To achieve supervisory approval a Iirm must demonstrate that it`s capital adequacy model has
passed various stress tests` and sensitivity analyses and is thus capable oI being calibrated to
the regulatory one-year 99.5` VaR level as speciIied in the SCR.
Firms will thereIore need to justiIy the assumptions underlying their model. They may take into
account Iuture management actions that they would reasonably expect to carry out in speciIic
circumstances, as long as the model makes allowance Ior the time necessary to implement such
actions. The model should be thoroughly documented, including an outline oI the model design
and details oI the methodology, data and assumptions used. Any major changes to the previous
version oI a model should also be documented.
Whilst the calculation oI assets and liabilities and the SCR can be determined either by an
approved internal model or by a standard approach, it is envisaged that the standard approach
would present more oI an approximation as it is more conservative in its valuation. Supervisors
may require Iirms to run their internal model on relevant benchmark portIolios and use
assumptions based on external, rather than internal, data in order to demonstrate that the
resulting capital requirements are appropriate. Some Iirms may be required to develop a Iull or
partial internal model iI the supervisor considers that their risk proIile deviates signiIicantly
Irom that assumed Ior the standard Iormula SCR.
c) Minimum Capital Requirement for Solvency II Framework
The MCR is the level oI capital below which policyholders are deemed to be exposed to an
unacceptable level oI risk and at which there is supervisory intervention. The calculation oI the
MCR is being considered at an 80 VaR conIidence level over a one year horizon.
There has been considerable diIIerence oI opinion among stakeholders on the methodology Ior
calculating the MCR. The Committee oI the European Assurance (CEA) argued that Iailure to
adopt a risk-based approach to the calculation oI the MCR in the proposed Solvency II
Framework Directive would perpetuate the disadvantages oI the current regulatory system
(CEA April 2008)
1
. They advocated that the MCR should be appropriately linked to the SCR so
that both reIlect the true risk proIile oI the insurer.
The CEA proposed a solution wherein the MCR oI a solo` operation is calculated annually as a
percentage oI the SCR and thereaIter reviewed and approved by the supervisor whether derived
Irom the use oI the standard Iormula or internal model. In conjunction with each calculation oI
the SCR, this percentage is then re-expressed as a percentage oI the insurer`s technical
provisions (or premiums as appropriate) to address the issues oI legal certainty and auditability
as well as to avoid any interim calculation oI the SCR. The CEA recommended a so called
compact` approach to the calculation oI the MCR which strikes a balance between risk
sensitivity and simplicity (see example below).
Example of MCR calculation
In this example, the assumption is made Ior a particular liIe company, wherein at year end the
1
CEA (Ed.). (2008, April 8). CEA position on Solvencv II and pension funds. Retrieved Irom http://www.cea.eu////position-paper.pdI
100
MCR calculated as a percentage oI the SCR (MCRFactor *Approved SCR) is 30 million and
technical provisions (Ior liIe) equal to 1.000 million. The MCR is thereaIter re-expressed as 3
oI technical provisions (i.e. 30/10003). Assuming that at a Iuture date (Ior example, 31/03),
the technical provisions are 1.100 million, the MCR would be 33 million (i.e. 3 oI 1.100
million). The 3 rate would thus apply until the next point when the SCR is re-calculated with
supervisory review. At that point, the MCR is re-calculated as a percentage oI the approved
SCR and then re-expressed as a percentage oI the updated value oI the technical provisions.
The CRO Iorum (Nov 2008) acknowledged that iI the MCR is not sensitive to risk and
diversiIication or does not give due credit to risk mitigation, it may create artiIicial constraints
and act as a disincentive to the use oI internal models and good risk management`. They argue
that such an approach would allow the MCR to act sensibly as the Iinal step in an escalating
ladder oI intervention.
d) Stress tests
Stress tests are an important part oI risk disclosure embedded within the system oI governance;
they are a key tool in the decision-making processes oI the undertaking, and should be
conducted regularly to reIlect the Iirm`s risk proIile.
Instead oI conducting Iinancial projection on a "best estimate" basis, a company may opt to
conduct a stress test` in order to examine how robust their risk position would be in the event
oI unIoreseen circumstances occurring such as a stock-market crash, interest rate hikes, or aIter
the acquisition oI a big insurance portIolio.
A Iorm oI stress testing was adopted in Switzerland, known as the Swiss Solvency Test (SST)
which calibrated a level oI intervention between the MCR and SCR equivalents. The
approach was as Iollows: the supervisor characterised a number oI historical scenarios
(e.g. stock market crash 2000/01, US interest rate crisis in 1994, terrorism, pandemic) and
Iirms computed how much capital would be absorbed as a result. The results suggest that on
average about 40 oI the SST SCR would be consumed iI any oI these scenarios materialised.
The intermediate level was thus set at 60 oI the SST SCR so that on average none oI the
scenarios pushed insurers beyond the second threshold oI the MCR.
The SST uses a Marginal Cost oI Capital (MCoC) approach to MVMs. Although the CRO
Forum`s proposed MCoC approach diIIers in several respects Irom the SST approach, the
Iundamental concepts are the same and thereIore insight can be gained based on the SST
experience.
The results oI the SST Field Test have shown that MVMs, under a MCoC approach,
appropriately reIlect the underlying risk inherent in the business. The Iollowing conclusions
were made by the CRO Forum (2007)
1
.
The calculation oI the MVMs during the Iield tests were Iound to be quite stable Irom
period to period;
1
CRO Forum. (2007, October 14). Feedback on Solvencv II Draft Directive. Retrieved Irom http://www.croIorum.org/
publication/onsolvency/
101
LiIe insurers writing mainly savings products tend to have relatively small MVM
since insurance risk is small compared to market risk;
LiIe insurers writing risk products have a large relative MVM since they have a large
exposure to biometric risk and a long duration oI the run-oII portIolio.
The CRO Forum argued that the SST approach could be applied in Solvency II to provide
evidence to calibrate the MCR. They advocated that CEIOPS should set out a number oI
relevant historical scenarios and undertake its own calibration study with the goal oI setting the
intervention level based on the evidence generated. Example: Suppose that on average x oI
the SCR is consumed iI any oI the stress test scenarios materialised. II the MCR equals x oI
the SCR one would expect about 50 oI the industry to breach the MCR as a result oI any oI
these events. CEIOPS and the Commission could equally test how many insurers would be
in breach oI the MCR Ior diIIerent values oI x and choose a value that avoids
generalised non-compliance with the MCR.
e) Own risk and solvency assessment (ORSA)
Each Iirm is obliged to conduct its own risk and solvency assessment` (ORSA), based on its
risk proIile, risk appetite and business strategy. ThereaIter the results are submitted to the
supervisor as part oI the supervisory review process
The ORSA acts as an internal control procedure used to monitor and manage risk and
highlights areas where the Iirm believes the assessment deviates Irom the assumptions
underlying the SCR calculation. The submission must include details oI the methods used and,
in cases where an internal model has been deployed, a recalibration that transIorms the internal
results so that they are consistent with the SCR calculations.
Risk management processes are required Ior the identiIication and quantiIication oI risk in a
coherent Iramework. These processes must be suIIiciently streamlined so there is no undue
delay in updating the assessment Iollowing any signiIicant change in the business risk proIile.
Firms must also demonstrate that this assessment has an inIluence on strategic decision making
and is not just a box-ticking` technical exercise.
The ORSA is an attempt to Iormalize best practice` in the insurance industry. The aim is to
ensure consistency between models used Ior internal management and Ior regulatory reporting.
Firms who present a thorough ORSA are in position to gain competitive advantage by making
more inIormed business decisions.
It appears unlikely that stress tests` and ORSA alone may be suIIicient to reassure regulators
that the risk management processes oI insurance Iunds are adequate. As the global economy
continues to ebb, some oI the carnage being leIt by the larger insurance / pension Iunds is
becoming more visible. The Iear is that as the tide goes out, the Iull, gruesome eIIect on some
oI Europe`s largest pension players is yet to be exposed. It is important thereIore that a wide
range oI risk management instruments are employed to guarantee that pension obligations can
be met.
102
f) Actuarial function
Firms are required to establish a strong actuarial Iunction in order to ensure a robust calculation
oI technical provisions. The actuarial Iunction will oversee the technical calculations, to make
sure that appropriate methodologies and data are used. Actuaries should also be involved with
risk modelling in terms oI calculation oI the SCR and the ORSA; in addition they are
responsible Ior underwriting policy and ensuring the adequacy oI reinsurance arrangements.
The CRO Iorum (2007)
1
argue that there should be no `prudence` included on top oI the market
value oI liabilities to cover the risk that the actual values vary over time Irom the current
market value estimates, as in the IORP Directive. They advocate that it is the purpose oI the
SCR to cover this risk and suggest that a mixed approach where some risks are considered
within the valuation oI assets or liabilities and some with the solvency requirement will
inevitably lead to inconsistencies, double counting and ultimately additional costs Ior
consumers.
g) Annual solvency and financial condition report
As part oI the public disclosure requirement under Solvency II (Pillar 3) Iirms will be required
to publish an annual report on solvency and Iinancial condition.
This report should cover:
The business in terms oI its perIormance and governance system;
A description oI risk exposure, concentration, mitigation and sensitivity by risk
category
The risk proIile and the assumptions underlying methods oI valuation Ior assets and the
technical provisions;
Details oI the capital management structure with a Iocus on the MCR and SCR;
Disclosure oI inIormation in relation to diIIerences between the standard Iormula and
any internal model used.
Much oI this material will already have been generated internally by Iirms who practise sound
risk management. However, additional checks and balances may be required by the supervisor
to ensure that the published details are both accurate and transparent.
h) Valuation of assets and liabilities
It is important that there is a market consistent valuation oI assets and liabilities. The Directive
stipulates that valuation oI assets and liabilities should be based on a total balance sheet,
market-consistent value based approach. Where the true market value is diIIicult to ascertain,
assets and liabilities should thus be valued on projected best estimate cash Ilows using market
consistent techniques.
1
103
i) Group supervision
Group insurance schemes will be supervised centrally on a consolidated basis that recognizes
group diversiIication beneIits so that there is one binding SCR Ior groups with a streamlined
regulatory process. As in the requirements Ior an individual Iirm, risk management, internal
control systems and reporting procedures need to be implemented and controlled on a
consistent basis at the group level. The annual solvency and Iinancial condition report may be
produced at the group level with inIormation covering both the group and subsidiaries.
The group needs to demonstrate that it has suIIicient Iunds to cover its SCR across the EC and
that there is no practical or legal restriction on the prompt transIer oI Iunds to support
subsidiary Iirms within the group. To this end the group supervisor will review annually any
signiIicant risk concentration at the level oI the group and any signiIicant intra-group
transactions.
The group-level SCR may be calculated using either the standard Iormula or an approved
internal model. The approval process Ior use oI an internal model is similar to that oI an
individual Iirm. However, should the supervisor suspect that the group model does not properly
reIlect the risk proIile oI the subsidiary, they will have the power to impose capital add-ons` to
the individual Iirm, or alternatively insist that its SCR is calculated using the standard Iormula.
104
Chapter 10 The economic (solvency) balance sheet and the MCoC
In their interpretation oI the CEIOPS QIS 3 building blocks, the CRO Forum (2007)
1
advocated
a market consistent approach to risk management through the application oI an economic
balance sheet` model. The main components oI the economic balance sheet are the market
value oI assets, the market consistent value oI liabilities and the solvency capital requirement.
A} The market cons|stent approach to r|sk management
Through the consistent measurement oI assets and liabilities, the economic balance sheet
distinguishes between the underlying asset and liability values and the capital required Ior
solvency purposes. This means that capital requirements consider risks emanating Irom both
sides oI the balance sheet, with both assets and liabilities evaluated on a market value basis.
Diagram 10.1: The economic (soIvency) baIance sheet
Source: CRO forum 2007
Diagram 10.1 depicts the main components and sub-components oI the market consistent
economic balance sheet. These comprise oI:
1. The market value oI assets (MVA);
2. The market consistent value oI liabilities (MVL);
3. The Solvency capital requirement (SCR).
1
105
1. Market value of assets (MVA)
The MVA in an insurance- based pension Iund is based on the mark to market` approach to
valuing assets, with the value being calculated by the Iund daily aIter the close oI the stock
exchanges. Each day the closing market value oI all securities owned is calculated along with
cash balances; total net assets are established by subtracting any liabilities, and the result is
thereaIter divided by the total number oI shares outstanding. The number oI shares outstanding
in the Iund can vary each day depending on the number oI purchases and redemptions.
2. Market consistent value of liabilities (MVL)
The MVL is derived Irom the cost oI managing the risks underlying the business on an ongoing
basis. Market values should be used where available to value the MVL, either Ior products in
their entirety or their constituent parts. Where market values are not available, market
consistent techniques should be applied in order to determine:
The expected present value oI Iuture liability cash Ilows;
The MVM Ior non-hedgeable risks.
a) Expected present value of future cash flows and the use of the SWAP rate
The calculation oI the expected present value oI Iuture liability cash Ilows includes giving
consideration to premiums, Iees, policyholder claims, expenses and commissions. All cash
Ilows that occur with certainty are deemed as being totally risk Iree and can be replicated with
risk-Iree assets oI a similar term. The CRO Forum (2007)
1
proposed that swap rates be used in
preIerence to Treasury bills as the 'risk-Iree yield curve Ior both the best estimate liability
valuation, and the market value margin valuation. Swaps allow liIe insurers and pension Iunds
to calculate discounted interest rates used Ior annuity closeout pricing in a simple, stable and
transparent way.
In many countries the market Ior swaps is deeper, longer and more liquid than the market Ior
government bonds. As a result swap rates have evolved Irom their Ioundation as a proxy AA
curve to a near-risk Iree curve at which counterparties trade risk in the Iinancial markets. It is
now standard risk management practise to use the swap rate` Ior the valuation rate oI hedging
instruments in the Iinancial markets.
The market consistent Iramework assumes that there is no reward Ior holding
diversiIiable risk. In other words, shareholders will only require an additional return Ior the
risks they take that cannot be diversiIied away. This assumption implies that any cash Ilows
that are not risk Iree but where risk is diversiIiable, should be treated as risk Iree and hence
discounted at the swap rate.
1
106
b) The market value margin (MVM) for non-hedgeable risks
The MVM Ior non-hedgeable risks represents the market consistent value at which the
liabilities could be transIerred to a willing, rational, diversiIied counterparty in an arms` length
transaction under normal business conditions.
It is necessary to determine in the Iirst instance whether the risks involved are hedgeable are
not. Diagram 10.2 outlines the process Ior making the MVL calculation.
Diagram 10.2: FIowchart for determining the appropriate method for caIcuIating the MVL
Source: CRO Forum 2007
The MVL may thus be interpreted as the cost oI setting up a replicating portIolio, the price oI
which can be determined Irom observable market prices.
3. The Solvency Capital Requirement (SCR)
The purpose oI the SCR is to cover all quantiIiable risks that the Iirm might Iace. It is the value
at risk (VaR) over a one year period to a 99.5 conIidence level (or 1 in 200 years). This Iorm
oI dynamic provisioning compels insurance companies to build capital buIIers` in good times
with a view to being able to absorb any unIoreseen downturn in the market.
107
} Us|ng the market cost of cap|ta| (Y6o6} approach to estab||sh the YVY for non-hedgeab|e
r|sks
The cost oI capital (CoC) is deIined as the minimum acceptable rate oI return Ior capital
investments, calculated on the basis oI a weighted average oI returns on debt and equity. This
weighting is related to the relative market value oI the portIolio oI debt and equity securities.
The cost oI capital reIlects the excess return over risk Iree rates or equity risk premium (ERP)
that the Iund would require to compensate them Ior holding capital to protect against non-
hedgeable risks. The ERP is calculated as the value oI a stock based on Iuture cash Ilows to
investors and is thus a key determinant oI the cost oI equity capital.
The cost oI equity capital Ior a Iirm 'J`, written 'R
E;J
can be derived Irom the ERP oI the
stock market using the Iollowing relationship:
R
E;J

J
x R
M
where R
M
is the long-run equity premium over the risk Iree rate R
I
, and the Iirm`s beta,
J
p x reIlects the correlation oI the Iirm`s returns with those oI the equity
market overall
where p is the correlation between segment 'J and the Iirm portIolio
1
.
The CoC in the context oI this section reIers to the capital charge on Iully diversiIied capital
held to cover non-hedgeable risks only. The CoC Ior non-hedgeable risks reIlects the excess
return over risk Iree rates that an acquiring company would require to compensate them Ior the
cost oI holding capital to run-oII the business. The CRO Forum (2006)
2
recommended that a
market cost oI capital approach (MCoC) to setting MVM`s Ior non-hedgeable risks is the most
appropriate method. In the Iirst instance it is important to make a distinction between hedgeable
and non-hedgeable risks.
(i) Hedgeable risks
A hedgeable risk is a risk which can be pooled or hedged in the Iorm oI a replicating portIolio
in order to protect against any downside eIIects Irom the market. Hedging instruments may
include derivatives that protect against a Iall in the stock market or currency Iluctuation. The
cost incurred by the insurer Ior such hedging would be reIlected in the market price oI the
derivative and associated transaction Iees
1
Open University.
2
CRO Forum. (2006, March 17). Market cost oI capital approach to market value margins, Retrieved Irom
http://www.actuaries.org.uk/data/assets/pdIIile/0009/27396/marketcostcapital.pdI
108
(ii) Non-hedgeable risks
In theory it should be possible to put a price on any Iorm oI risk. However, in order to be
reasonably sure that the price accurately represents the market value oI liabilities to which a
pension Iund is committed, it is necessary to have a deep and liquid market with a range oI
instruments and prices that match the risk.
Risks Ior which a deep and liquid market is not available are reIerred to as being non-hedgeable
in that there is no given market price Ior these types oI risks. Non-hedgeable risks include:
LiIe insurance(mortality, morbidity, persistency, expense);
P&C (catastrophe, basic losses, large losses, pricing risk);
Market (interest rate risk, volatility risk);
Credit risk.
1. The market value margin for non-hedgeable risk
To compensate an investor Ior the cost oI taking non-hedgeable risks, an explicit MVM in
addition to the expected present value oI Iuture cash Ilows is demanded. Under the MCoC
approach, the MVM is deIined as the cost oI risk, i.e. a risk margin in addition to the expected
present value oI Iuture liability cash Ilows required to manage the business on an ongoing
basis. It is estimated in terms oI the present value oI the cost oI Iuture capital requirements Ior
non-hedgeable risks over the liIe oI the policy, including those annuity payments made
thereaIter Irom reserves. The MVM is added to the best estimate liability value in order to
improve transparency and Iacilitate companies` analysis oI the risks they take.
The cost oI capital Ior non-hedgeable risks thus reIlects the excess return over risk Iree rates
that an acquiring company would require to compensate them Ior the cost oI holding capital to
run-oII the business.
The MCoC approach attempts to garner a market consensus Ior the risk margin making it much
easier Ior regulators and supervisors to comprehend and manage. The CRO Forum (2006)
1
oIIer`s the Iollowing reasons Ior using the MCoC approach:
It supports appropriate risk management actions;
It provides a more appropriate reIlection oI risk, both in terms oI risk type and between
product groups;
It ensures a better response to a potential crisis in the insurance industry;
It allows Ior simpliIying assumptions, which makes this approach easy to implement;
It is transparent, easily veriIiable and understandable by the supervisor and other
constituencies;
It passes the 'use test envisioned in the Solvency II Iramework.
1
CRO Forum. (2006, March 17). Market cost of capital approach to market value margins. Retrieved Irom
109
2. Application of the MCoC approach to MVM`s
The MVM Ior non-hedgeable risks is calculated using the Iollowing approach:
1. Project the SCR Ior non-hedgeable risks Irom time 1 until the run-oII oI the portIolio;
2. Calculate the capital charge at each projection year (t) as the SCR multiplied by the
CoC charge, Ior non-hedgeable risks, in order to arrive at a MVM(t);
3. Discount the projected capital charge to determine the MVM.
Step 1: Project the SCR Ior non-hedgeable risks
When applying the MCoC approach, the SCR used to calculate the MVM is measured in terms
oI the VaR over a one year period to a 99.5 conIidence level (or 1 in 200 years). The MVM
is the present value oI the cost oI maintaining the SCR on a yearly basis. The SCR is thereaIter
estimated over the liIe oI the business and thus represents the change in liability value between
expected Iuture liability cash Ilows and a worst-case 99.5 percentile cash Ilow scenario.
In order to determine the MVM, the SCR Ior non-hedgeable risks must be projected Ior all
Iuture time periods i.e. Irom time 1 until the portIolio has run-oII. Using either the standard or
internal models, the solvency capital requirement Ior covering non-hedgeable risks is calculated
at time 0 Ior the projected period oI t1 to the run-oII oI the business
Step 2: Calculate the capital charge
Once capital has been projected Ior all Iuture time periods, the next step is to calculate the
capital charge at each point in time until run-oII. The capital charge Ior non-hedgeable risks can
be explicitly calculated by multiplying the Iuture SCR at each point in time by the CoC Ior
non-hedgeable risk.
Step 3: Discount the capital charge
The Iinal step in calculating the MVM is to discount the projected capital charge stream at the
risk Iree rate Ior which the swap rate is used.
3. Calculating the MCoC for pension funds
The MCoC approach can be applied to both liIe insurance business and pension Iunds. For an
existing Iund, an SCR Ior non-hedgeable risk is set up Ior the current year to support the
insured risk. In addition, an SCR will be put in place to cover the non-hedgeable reserve risks
that may occur aIter the expiration oI the contract. These would include risk that reserves may
not be suIIicient to cover pension annuity payments that have not been incorrectly estimated.
The MCoC approach applies to both the current SCR and Iuture SCR (reserve risk) and
thereIore both contribute to the determination oI a MVM. As the risk associated with pension
Iund liabilities spans over Iuture years, it is necessary to discount reserves accordingly. This is
Iurther illustrated in Diagram 10.3 below.
110
Diagram 10.3: CaIcuIating the MVM for pension funds
4. The replicating portfolio
The replicating portIolio or hedge portIolio is the portIolio oI assets that most closely matches
the corresponding liability cash Ilows (see diagram below). In the absence oI arbitrage, the
market consistent value oI the liabilities should match the market value oI the replicating
portIolio.
The replicating portIolio must be set up to cover all Iuture cash Ilows other than those relating
to proIit or gains. Future cash outIlows are assessed net oI expected Iuture premium inIlows,
thus allowing Ior the expected run-oII oI policies due to claims, lapses and surrenders.
Diagram 10.4: The repIicating portfoIio
111
5. Role of the SCR in times of crisis
The aim oI creating an SCR is to have a precautionary buIIer in place so that the insurance
company or pension Iund will be able to survive a stressed situation occurring and remain in
place Ior the liIe oI the business. As the situation unIolds, the insurance company may Ieel the
need to revise their expectations oI Iuture liability cash Ilows and thus recalculate the SCR and
therein MVM so that it is consistent with changes in the market environment.
Should the worst-case scenario occur, the SCR would ensure that the business was still
attractive enough to reward either a third party Ior accepting the liability or alternatively entice
new capital providers into the equation.
Recent events have demonstrated that economic theory and practise are two separate things. In
eIIect the low hanging Iruit` oI pension strategy, may not always be the most appropriate
course oI action. When a pension scheme is struggling to meet its commitments, policyholders
may opt Ior the liabilities to be taken over by an insurer that is a going concern supported by
suIIicient Iinancial resources to cover the liabilities. The key issue Ior the pension scheme in
such a buy-out` is assessing the amount oI risk that is actually being removed and in turn
calculating iI the buy-out price will exceed the expected cost oI providing the beneIits
themselves through the pension scheme. To this end the pension scheme needs to judge
whether iI adopting a similar investment strategy to that used by the insurer that it would be
able to run-oII the liabilities at a cost below the buy-out price.
The CRO Forum acknowledges that the existence oI the SCR guarantees that the insurer will be
able to survive stressed situations occurring within one year and still be in a position to meet its
obligations. It Iocuses on the market consistent value oI assets and liabilities and thereIore the
calculation ensures that all inIormation received during the year such as potential loss and also
any potential reassessment oI Iuture risk, including any potential run-oII situation in terms oI
the liabilities, is properly reIlected. In particular, the MCoC approach ensures that aIter such an
event the company will be able to appropriately remunerate either a third party accepting the
liability or new capital providers. This is achieved through the calculation oI the SCR Ior non-
hedgeable risks needed to support the liability in Iuture years and hence the MVM, which
represents a provision Ior the cost oI holding this capital.
6} we|ghted average cost of cap|ta| (wA66} approach
Investment decisions are based on the company`s cost oI capital or in terms oI the debt/equity
rate usually reIerred to as the weighted average cost oI capital (WACC). The weighted average
cost oI capital is the expected rate oI return on a portIolio oI all the Iirm`s debt and equity
securities with an adjustment Ior tax relieI on interest payments made to service the debt.
There is oIten a conIlict between the long term objectives oI a pension Iund and the pressure
Irom shareholders Ior returns in the shorter term. This may result in CFO`s working to a much
shorter time horizon than pension Iund trustees. A major Iactor in the equation oI what type oI
assets to invest in is the calculation oI the WACC. The cost oI equity capital is a key input oI
112
the WACC. The cost oI equity Ior a Iirm can be derived using the Capital Asset Pricing Model
(CAPM) along with estimates oI the equity risk premium (ERP) oI the stock market as Iollows:
=
+
+ (1 - )
+
where
E: is the market capitalization
D: is the market value oI debt, and
: is the eIIective tax rate
The market or equity risk premium (ERP) is deIined as the diIIerence between the return on the
market and the interest rate on Treasury bills. When setting the ERP, the objective is to
examine historical realized returns on the stock market in excess oI the government bond yield
over an extended time period in order to ensure stability oI estimation. Over the last century,
the average market risk premium, or what additional return an investor would expect Irom
investing in the stock market rather than Treasury bills, has been 7.7 (Brealey et al, 2004)
1
.
There is a however a lot oI scope Ior argument as to what market risk premium should be going
Iorward. Dimson, Marsh and Staunton (Fall, 2003)
2
in their paper 'Global Evidence on the
Equity Risk Premium by, Journal oI Applied Corporate Finance, conducted a comprehensive
study oI equity risk premia and concluded that: 'A plausible, Iorward-looking risk premium
Ior the world`s major markets would be on the order oI 3 on a geometric mean basis, while
the corresponding arithmetic mean risk premium would be around 5.
To this end the Iigure oI 4 (average oI 3 and 5 as mentioned above) has been selected as
the cost oI equity capital (in excess oI risk Iree) in the illustration below. In addition, the Iigure
oI 2.1 is used Ior the cost oI debt (in excess oI risk Iree), based on the analyzed monthly data
oI promised yield on Aaa and Baa corporate bonds and 10-year Treasury bonds Irom February
1970 to May 2003(Lamdin (2003)
3
.
An illustrative example
The calculation assumes that a pension Iunds surplus is made up oI 80 equity capital and 20
Irom debt. A risk Iree rate oI = 4 has been selected along with an estimate Ior the cost oI
equity capital oI = 4.0 (in excess oI risk Iree). In addition, a cost oI debt capital oI =
2 (in excess oI risk Iree) and a tax rate oI 35 (adjusted Ior tax savings due to interest
1
Brealey, R. A., Myers, S. C., & Marcus, A. J. (2004). Ch 10; Introduction to Risk, Return and the Opportunity Cost oI Capital. In
Fundamentals of Corporate Finance (4th ed., p. 271). Mc Graw Hill.
2
Dimson, E., Marsh, P., & Staunton, M. (2003, Summer). Global Evidence on the Equity Risk Premium. Journal of Applied Corporate
Finance, Jol.15(No 4).
3
Lamdin, D. (2003). Corporate bond yield spreads in recent decades: an examination oI trends, changes, and stock market linkages. Business
Economics, Jol.39, Pp28-39.
113
payments) are used. By applying the WACC, the resulting estimate oI the CoC Rate oI
approximately 3.2 is calculated as Iollows:
= ( + )
+
+( + )(1 - )
+
-
=
(
4.u%+ 4.u%
)
X u.8 +
(
2.1%+4.u%
)
X (1 - u.SS )X u.2 -4.u%
3.19
The calculation oI the cost oI capital allows Iund managers to generate various scenarios Ior the
return on the pension portIolio. Managers may set a target Ior the estimated long-term excess
returns versus government bonds oI between 2-4.5. In times oI increased regulation, there
will be a smaller swing in bond prices as the regulator tries to limit Iinancial and economic
risks. On the other side oI the equation, a booming economy oIten leads to low cost oI capital,
which translates into excess capacity which results in low proIits per unit oI capital and therein
depressed equity returns.
114
Chapter 11 Comparison of the IORP and Solvency II models
There will always be a series oI hurdles to overcome when applying two diIIerent models to
solve a problem as complex as pension Iund management. At times such an exercise is akin to
pushing square pegs into round holes`; however there are many areas oI overlap between the
models. Ultimately the two models complement each other in that they are designed to reduce
the risk to pension Iund investors.
A} App|y|ng 0|8 3 to a 'f|na| pay' pens|on p|an
In a bid to compare the two main European pension models, Peek et al (2008)
1
analysed what
the quantitative Iunding requirements would be, iI the insurance-based Solvency II approach
(based on the QIS 3 methodology) would be applied to pension Iunds with deIined beneIit
plans. A number oI possible extensions oI the Solvency II methodology were discussed in order
to reIlect the speciIics oI DB pension Iunds. This readjusted pension model revealed that the
required Technical Provisions Ior a standard Iinal pay pension plan using the QIS 3 approach
would be 25 higher using the IAS 19 DBO (International Accounting Standard 19 DeIined
BeneIit Obligation), which covers employee deIined beneIit occupational schemes under the
accounting system oI the International Financial Reporting Standards. This valuation method
Iacilitates the projection oI unit credits based on accrued pension beneIits including an
allowance Ior Iuture salary increases. The two key reasons Ior this 25 diIIerence were as
Iollows:
The discount rate` used in the Best Estimate oI Liabilities (BEL), or expected beneIit
payments, would be calculated using the risk Iree term structure, whereas the IAS 19
DBO uses a single discount rate which is the sum oI the risk Iree yield and the AA
corporate spread (this is assumed to equate to an additional 50 basis points). This results
in lower discount rates under Solvency II and thus increases the BEL.
The IAS 19 DBO does not include a Risk Margin
In addition to the technical provisions`, the QIS 3 model requires additional capital to support
the SCR in order to cover market risk, interest rate risk and longevity risk. The end result is that
aIter allowing Ior the SCR, the Iunding level Ior this variant oI deIined beneIit pension would
be reduced to 65 (Peek et al 2008)
2
. This exercise thereIore demonstrates that the solvency
requirements could not be IulIilled Ior the generic Iinal pay plan given that Solvency II requires
all undertakings to have a minimum 100 Iunding level.
1
2
115
The analysis argued that the SCR could be decreased by adjusting the asset allocation. The
asset allocation is an important driver oI the SCR to the extent that a reduction oI equity risk
could be achieved by reducing the equity exposure oI the portIolio. Alternatively, a better
match oI assets and liabilities would also help reduce exposure to risk.
Pension plans with risk sharing
The sharing oI risk between the sponsoring company and plan members via the contribution
policy is an important Ieature oI pension Iunds. In an underIunded situation, the plan sponsor
may be required to make additional contributions or alternatively plan members may be asked
to increase Iuture contributions. These mechanisms do not occur in the liIe insurance sector
where there seems to be no general agreement on how to best reIlect this type oI risk sharing in
a risk based Iunding Iramework such as Solvency II. The danger however in using a risk
sharing approach is that it may be reIlected in a reduction in the amount oI security on oIIer;
the recalibration oI the SCR and associated Risk Margin would thus lead to increased Iunding
levels.
Peek et al (2008)
1
observed that a contribution commitment by the sponsor could be reIlected
in the pension Iund`s solvency balance sheet in a number oI diIIerent ways. One example could
be Ior the sponsor`s credit rating to be directly reIlected in the calculation oI the SCR by taking
into account Iuture probabilistic solvency oI the sponsoring company. Alternatively, the
sponsor could be allowed to set up the SCR in a separate Iund, instead oI increasing the Iunding
oI the pension Iund itselI. Both approaches would reduce the pension Iund`s SCR. Other
protection mechanisms such as guaranteed protection Iunds (Iire Iunds) as well as allowance
Ior recovery periods might also be taken into consideration.
BeneIit cuts are another way Ior pension Iunds to share risks with plan members. When the
Iunding level oI the pension Iund is below a certain level, in this case 100, the beneIit
payments may be cut. This means that the plan members cover some part oI the losses oI the
pension Iund should the Iunding level oI the pension Iund deteriorate.
Overall, the Solvency II Iunding level oI the pension plans with risk sharing Ieatures is higher
compared to the plans without risk sharing. The amount oI improvement varies depending on
the type oI risk sharing and the associated management rules.
Peek et al summarized the results as Iollows:
Compared to an initial Iunding level oI 100 based on IAS 19 DBO, the application oI
a Solvency II structure would require a dramatic increase in Iunding level Ior pension
Iunds.
SigniIicant changes in asset allocation are necessary in order to reduce SCR (e.g. lower
equity exposure).
The Solvency II methodology makes allowance Ior risk sharing with plan members.
1
116
This leads to a reduction oI SCR.
The QIS 3 model has to be modiIied in order to account Ior the speciIic risks oI pension
Iunds, in particular regarding inIlation risk and salary increase risk.
Further conceptual work seems necessary in order to properly reIlect risk sharing with
sponsoring company or plan members (e.g. via reduced security level or based on credit
rating oI sponsoring company).
} The quest for greater secur|ty for benef|c|ar|es
The IORP Directive has helped to harmonize the second pillar oI member countries in terms oI
the supply oI suitable Iinancial pension products. It paves the way Ior multinational Iirms to
centralize the investment side oI their pension business by choosing a site Ior their operations
in a single EU-member country. While this will lead to cost savings, the liability side oI the
pension business will remain segmented because IORP`s are obliged to respect Iully the
provisions oI the social and labour law in Iorce in the diIIerent countries where they provide
their services. The Directive championed the cross-border extension oI Ireedom oI choice
between diIIerent types oI pension providers. However, the current application oI the Directive
has resulted in variations in national solvency standards, which has in turn led to regulatory
arbitrage between Member States.
By contrast, the Solvency II approach argues that in a single EU market Ior pensions,
competition should be between providers and the variation oI scheme characteristics,
rather than between supervisory regimes. The Solvency II proposal Ior insurance companies
seeks to bring about consistent and harmonized supervision across the EU with the aim oI
delivering better overall risk management, improved mobility oI workers and a level playing
Iield Ior all pension providers. Solvency II has the potential to bring huge improvements to the
European insurance and pensions industry. It will level the playing Iield by ensuring consistent
regulation in all territories. It oIIers the beneIits oI better capital management by aligning
solvency with the risk proIile oI each Iirm, which in turn will result in better protection Ior
consumers.
The Iundamental debate between these two Iorms oI pension systems is on the level oI security
extended to beneIiciaries. Pension investments diIIer in risk values Irom those oI commercial
insurance undertakings, Ior which Solvency II was intended. Risks Ior pensions are oIten
shared between pension Iunds, employers and employees. Occupational pension Iunds thus do
not oIIer the same level oI protection in terms oI solvency capital saIeguards. Although
IORP`s are not included in the scope oI the Solvency II project, discussions are currently
ongoing as to whether the Solvency II requirements Ior insurance companies should be
extended to pension Iunds as well. To this end, insurers are now lobbying Ior the development
oI an appropriate Iramework to supervise all Iorms oI occupational pensions at the European
level.
The Iact that the implementation oI the IORP and Solvency II Directives has been such a long
process highlights the scale oI the tasks involved. The success to date oI the Directives
demonstrates that harmonisation oI the industry is possible. However with additional Member
States being added to the European project, each oI which is at a diIIerent stage in terms oI
capital regulation, the challenge becomes even greater. Ultimately, the winners in Europe will
be those companies who take the opportunity to really embed the IORP and Solvency II
principles into their corporate culture so as to ensure a better way oI doing business.
117
Summary of research findings on EU pension legislation
An interesting statistic revealed itselI when the survey target audience was asked iI they
considered EU legislation with regards the governance oI pension schemes diIIicult to
understand. Diagram 11.1 demonstrates that over 36 oI respondents either agreed or strongly
agreed that this was the case. Surprisingly 54 oI those surveyed voiced no opinion on this
matter; however a more in depth look at these responses revealed that the majority oI these
came Irom UK based pension administrators and represented companies with little or no
activity outside oI UK borders. Those pension Iund representatives oI companies with cross
border activities were Iirmly situated in the agree / strongly agree camp.
Diagram 11.1: Research findings on EU pension IegisIation
EU legislation with regards the governance of cross border pension schemes is difficult to understand.
c. No opinion 12 54.55
b. Agree 5 22.73
a. Strongly agree 3 13.64
d. Disagree 1 4.55
e. Strongly disagree 1 4.55
Total: 22
Source: The Pension Siren - International Pension Survey (2010)
118
Part IV
Chapter 12 Asset allocation
Asset allocation is an integral part oI a pension plan structure in that investment returns are
dependent on where and when the assets are actually invested. Asset allocation involves the
distribution oI assets among diIIerent investment choices or classes. The investment allocation
oI the Iund is oIten a traditional mix oI asset classes which would include equities, bonds, cash,
real estate, etc. The main asset classes are thereaIter divided Iurther into subclasses, such as
small-cap stocks or corporate bonds. In addition, alternative asset classes may be employed
using commodities or hedge Iunds.
A} Asset a||ocat|on approaches
Market conditions such as volatility, increasing correlations between markets and lower real
interest rates have highlighted a number oI problems associated with traditional investment
approaches. When equity markets are buoyant, pension Iunds will have overIunded positions,
with more than suIIicient liquidity to meet the plan's Iuture liabilities to members. However, the
recent turbulence in equity markets has exposed some oI the inadequacies in current portIolio
construction techniques. The result has been an erosion oI surpluses and the exposure oI
structural Ilaws in the Iunding levels oI deIined-beneIit pension plans with the value oI assets
being signiIicantly reduced in absolute terms.
Sound investment decision-making is thus oI increasing importance in pension Iund
management. Nowadays the role oI the pension portIolio manager can be likened to that oI the
conductor oI an orchestra, with the unenviable task oI having to keep all assets in concert with
one another in order to deliver to the audience: the pension Iund members.
1. Strategic asset allocation
The primary aim oI a pension asset allocation model is to arrive at a set oI risk and return
parameters that provide the Iund with the necessary returns and liquidity with which to meet
pension liabilities. As such liabilities are typically longer term, an appropriate strategic asset
allocation (SAA) approach is required in order to achieve long-term investment goals and
satisIy the risk based Iunding requirements oI the pension Iund.
An alternative approach to investment decisions is that oI tactical asset allocation (TAA),
which Iocuses on exploiting opportunities in the ever changing capital markets by shiIting the
asset mix temporarily away Irom the normal strategic position.
Inderst (2008)
1
, noted that discussions in the pension industry have intensiIied around the
Iollowing subjects:
What is the right asset allocation strategy Ior pension Iunds?
How should asset allocation decisions be taken, and by whom?
How should the policy be implemented and changed over time?
1
Inderst, G. (Ed.). (2008). INJESTING PENSION PLAN ASSETS. Retrieved Irom IPE.com website: http://www.ipe.com//contents.php
119
The asset allocation oI pension Iunds diIIers not only within countries but also between
countries. Many pension Iunds are restricted by law regarding the types oI investments they can
make. Pension Iunds in Anglo-Saxon countries generally invest a larger share oI their assets in
equity and alternative investments than pension Iunds in continental Europe, which tend to opt
Ior a greater weighting in Iixed income securities.
Inderst (2008)
1
observes that asset allocation is inIluenced by a long list oI Iactors, the
importance oI which varies considerably across countries and over time. These include:
Legal constraints (eg, quantitative restrictions imposed by law);
The type oI pension provision (deIined beneIit, deIined contribution, cash balance);
The regulatory regime (eg, Iunding rules or solvency requirements imposed by the
supervisory authorities);
Taxation (oIten diIIerent Ior diIIerent asset classes);
The constitution oI the plan and sponsoring arrangements (public or private sponsor;
industry-wide plans);
The size oI the pension Iund and strength oI the sponsor;
Accounting standards;
The membership proIile;
Advice given by actuaries, investment consultants, Iund managers;
Risk tolerance oI pension Iund trustees and sponsors;
The pensions investment culture and history.
The SAA approach will also diIIer depending on the pension model employed by the scheme
provider; thus pension plans that conduct their aIIairs under the Solvency II model have greater
risk based Iunding requirements than their IORP counterparts.
2. Multi asset allocation
Fund managers may propose a multi asset allocation model to Iund sponsors, wherein a
selection oI assets is oIIered across a range oI classes. This model can be managed either
dynamically or strategically depending upon how the Iund manager views the market
landscape. A dynamic management approach may have an equity allocation ranging Irom zero
to 70 investment in equities. The Iund manager would act according to the yield, in that a
negative or positive result over a six month cycle could have the portIolio asset allocation
altered to reIlect the changing market conditions. The asset allocation decision in a bullish or
bearish market is thereIore a key Iactor in delivering results.
} The |nf|uence of cu|ture on asset a||ocat|on
HoIstede (1980)
2
deIined national culture as 'the values, belieIs, and assumptions that are
learned in early childhood and distinguish one group oI people Irom another. HoIstede
identiIied Iour work-related value-based cultural dimensions that have an eIIect on the way
people behave. These are as Iollows:
1
2
HoIstede, G. (1980). Cultures Consequences . International Differences in Work-Related Jalues. Newbury Park, CA: Sage.
120
Uncertainty Avoidance (UAI)
Power Distance (PDI)
Masculinity-Femininity (MAS)
Individualism-Collectivism (IDV)
A IiIth cultural dimension associated with long term orientation` (LTO) emerged through
additional observational research which distinguished between the values oI thriIt and
perseverance, as opposed to those oI short-term orientation` such as respect Ior tradition,
IulIilling social obligations, and protecting one's image (HoIstede and Bond,1988)
1
.
Culture inIluences how individuals and institutions respond to changes and to economic
opportunities. The cultural dimensions model can be used to help explain variations in the asset
allocation oI pension Iunds across EU Member States. De Bruijne (2005)
2
tested the
hypothesis that:
'In countries with a higher uncertainty avoidance index (UAI), pension Iunds will invest less in
equity than in countries with lower uncertainty avoidance index.
Uncertainty avoidance is a measure oI a society's tolerance Ior uncertainty and ambiguity in
terms oI an unknown Iuture. The results oI the research showed that the Anglo-Saxon and
Germanic countries oI Europe regarded uncertainty in society and the Iuture as an unavoidable
Iact. This cultural position is reIlected in a greater willingness to take risks. In countries that
scored high on the UAI, such as France, Belgium and Greece uncertainty is experienced as a
permanent threat that must be mitigated through control and regulation (see diagram below).
Diagram 12.1: Hofstede's vaIue-based cuIturaI dimensions
Uncertainty Avoidance Index
Flexible Rules / Regulations
Pragmatic Conservative
Gamble Control
1
HoIstede, G., & Bond, M. H. (1988). The ConIucius connection: Irom cultural roots to economic growth. Organi:ational Dvnamics,
Jol.16(No.4), 4-21.
2
de Bruijne, P., Dr. (2005, May 29). ING Group and Pension Funds.International Differences. Lecture presented at Armenian International
Policy Research Group, Tsakhkadzor, Armenia.
120
1
.
2
tested the
hypothesis that:
Gamble Control
1
Jol.16(No.4), 4-21.
2
120
1
.
2
tested the
hypothesis that:
Gamble Control
1
Jol.16(No.4), 4-21.
2
121
Through the testing oI the hypotheses, de Bruijne observed the impact oI cultural Iactors on
asset allocation in terms oI those countries that demonstrated a high degree oI uncertainty
avoidance in their behavior. These European countries tended to opt Ior a relatively lower
equity weighting oI 55 in their portIolios` compared to their Anglo Saxon counterparts,
which at the time preIerred a 65 exposure.
C) A current v|ew of pens|on fund asset a||ocat|on
A recent survey by Towers Watson (2010)
1
displays the evolution oI pension Iunds in a select
number oI Western European countries in terms oI assets under management over the last 10
years (see table 12.1 below).
1. European pension fund asset evolution 1999 - 2009
The survey revealed the roller-coaster` eIIect that the upheaval in the marketplace had Ior the
level oI Iunds under management.
TabIe 12.1: European pension fund asset evoIution 1999 - 2009 - EUR biIIion
1oLal AsseLs 1oLal AsseLs
MarkeL Lu8 (bllllon) Lu8 (bllllon)
?ear-end 1999 ?ear-end 2009
lrance 38 140
Cermany 148 323
lreland 39 80
neLherlands 314 779
uk 1091 1410
1oLal (Lu8) 1630 2732
Source: Adopted from Towers Watson global pension asset study (2010)
*Note: UK Iigures exclude personal and stakeholder DC assets
2. European pension fund asset evolution 2007 - 2009
Towers Watson recorded that the value oI European pension assets at the end oI 2009 was EUR
2,732 billion, aIter having recovered Irom the 2008 collapse in the stock markets. The 2008
Iigures were almost EUR 800 billion or 25 lower than 2007(see Table 12.2). The drop in
assets between 2007 and 2008 was largely explained by the poor perIormance oI markets
around the world and the high exposure oI pension Iunds to equities. By the same token, the
recovery in assets under management can be put down to the revival oI the markets in 2009 and
the high Iund exposure to equities; assets however are still well below levels achieved at the
end oI December 2007.
1
assets///.pdI
122
1oLal AsseLs 1oLal AsseLs 1oLal AsseLs
MarkeL Lu8 (bllllon) Lu8 (bllllon) Lu8 (bllllon)
?ear-end 2007 ?ear-end 2008 ?ear-end 2009
lrance 127 113 140
Cermany 273 284 323
lreland 93 63 80
neLherlands 743 649 779
uk 1983 1306 1410
1oLal (Lu8) 3223 2419 2732
3. The evolution of European pension assets
The European countries oI those surveyed which managed to retrieve and surpass the 2007
levels oI pension Iunds assets under management by the end oI 2009 were France, Germany
and the Netherlands (see Diagram 12.2 below). These countries had a much lower exposure to
equities throughout 2007 - 8, thus conIirming that cultures which are more conservative in their
approach to asset allocation can avoid pitIalls by steering clear oI uncertainty.
Diagram 12.2: The evoIution of European pension assets
Source: Adopted from Towers Watson and various secondary sources - Global pension asset study (2010)
The pension survey highlighted that the issues Iacing global pension markets amid the Iinancial
crisis included liquidity, the management oI credit/collateral risk and asset manager
underperIormance along with the new challenges in strategic asset allocation.
4. Diversification
The Towers Watson survey results showed that many pension Iunds seek to pursue a wider
range oI asset strategies in order to diversiIy their portIolios. Property is by Iar the most
popular alternative to equities and bonds, though the proportion oI Iunds investing in this asset
class dropped during 2009 Irom 25 to 20 in the UK. A larger proportion oI Continental
European Iunds continue to invest in property despite the recent collapse. UK pension Iunds
have historically invested in domestic property markets. However, given the current depressed
value oI property on British shores, Iunds are beginning to look Iurther aIield to international
markets in an attempt to enhance returns.
lrance
Cermany
lreland
neLherlands
uk
Luropean pens|on assets
Lvo|ut|on 1999-2009 - LUk b||||on
122
lrance 127 113 140
Cermany 273 284 323
lreland 93 63 80
uk 1983 1306 1410
1oLal (Lu8) 3223 2419 2732
4. Diversification
Luropean pens|on assets
Lvo|ut|on 1999-2009 - LUk b||||on
2009
1999
0 1000 2000 3000 4000
lrance
Cermany
lreland
neLherlands
uk
1oLal (Lu8)
Luropean pens|ons assets
Lvo|ut|on 2007 - 2009 LUk b||||on
122
lrance 127 113 140
Cermany 273 284 323
lreland 93 63 80
uk 1983 1306 1410
1oLal (Lu8) 3223 2419 2732
4. Diversification
3000 4000
Luropean pens|ons assets
Lvo|ut|on 2007 - 2009 LUk b||||on
2009
2008
2007
123
An additional Iactor to consider when purchasing international property and other assets which
are globally distributed is the control oI currency risk. The proportion oI Iunds using active
currency management in the UK has increased Irom 7 to 8. In Continental Europe and
Ireland, this proportion is 4. Tactical Asset Allocation (TAA) has also gained traction in the
UK, with the proportion oI Iunds using this investment approach increasing Irom 2 to 5. In
Continental Europe and Ireland, 3 oI Iunds have exposure to TAA. Both active currency and
TAA are expected to grow in popularity over the next year.
DiversiIication into alternative assets which included property and derivatives continued in
2009. The Towers Watson research revealed that as oI the end oI 2009 pension portIolios in
the UK and Ireland had a larger proportion oI Iunds allocated to risky` assets, whereas the
Netherlands and France adopted more conservative investment strategies with the emphasis on
bonds as opposed to equities. This marked shiIt Irom equities to bonds was largely as a result oI
the poor perIormance oI stock markets over 2009 coupled with a more conservative attitude by
the Netherlands, France and Germany towards portIolio management.
Diagram 12.3: European pension fund asset cIass breakdown 2009
Diagram 12.3 illustrates the diversiIied investment strategy oI pension Iunds with a mixture oI
shares, bonds and investment Iunds being held by a select number oI countries. The pension-
Iund asset allocation diIIers signiIicantly across countries thus reIlecting the diversity oI
individual legal and regulatory regimes. Investments in the bond market remain the pre-
dominant option Ior pension Iunds in Continental European countries. It is envisaged that the
trend towards reIuge in bonds will continue due to growing interest in liability hedging and de-
risking strategies. To this end the structure oI bond portIolios and associated benchmarks are
increasingly being used as a risk management tool in Europe. Meanwhile, exposure to cash and
other alternative assets has continued to grow, extending an established trend and reIlecting
pension Iunds` growing appetite Ior diversiIication.
Irish institutional investors remain more heavily invested in equities than their European peers,
with a lower weighting in lower-risk bonds. Despite the small size oI the Irish Stock Exchange
in global terms, Irish investors have a higher average exposure to domestic equities than any oI
the other countries surveyed across Europe.
28
lrance
Cermany
lreland
neLherlands
uk
Asset A||ocat|on 2009
LqulLles
123
33
32
39
28
60
46
62
24
48
31
12
4
7
24
6
10
2
10
1
3
Asset A||ocat|on 2009
LqulLles 8onds Cash CLher
123
4
6
10
2
10
1
3
124
Pension Iunds in the Netherlands displayed a signiIicantly lower exposure to equities and
higher allocation to bonds in their asset allocation. As a result, they experienced a lower decline
in assets during 2009 than those with higher equity allocation. On the other hand, the UK who
displayed an above-average allocation to equities, suIIered Irom the collapse in the markets
during 2008, but also recovered positions Iaster throughout 2009 as a result oI greater equity
exposure (see Diagram 12.4 below). It is also envisaged that exposure to active currency and
tactical asset allocation will increase this year, as Iunds seek to diversiIy their risk
Diagram 12.4: Pension asset aIIocation in the NetherIands and the UK
5. European pension funds under management versus GDP
The ratio oI pension assets to GDP Iell signiIicantly over 2009, with Ireland, the Netherlands,
and the UK all experiencing dramatic reductions on their 2008 levels. The longer trend is oI
particular concern given that both Ireland and the UK are well below 1999 ratio levels (see
Diagram 12.5 below). Such low Iigures iI not addressed imminently could have a damaging
eIIect on the Iuture spending power and therein economies oI these countries.
Diagram 12.5: European pension funds under management versus GDP 2009
GDP values Irom IMF, taken in USD at current prices
0
20
40
60
80
100
uec
1999
uec
2004
uec
2009
Nether|ands - ens|on assets a||ocat|on
lrance
1999 3
2009 6
0
30
100
130

o
f

G
D
Luropean pens|ons vs. GD

124
uec
2009
Nether|ands - ens|on assets a||ocat|on
CLher
Cash
8onds
LqulLles
0
20
40
60
80
100
uec
1999
uec
2004
uec
2009
Uk - ens|on assets a||ocat|on
lrance Cermany lreland
neLherlan
ds
uk
3 9 34 103 92
6 12 43 120 80
Luropean pens|ons vs. GD
1999 2009
124
uec
2009
Uk - ens|on assets a||ocat|on
Cash
CLher
8onds
LqulLles
uk
92
80
125
Chapter 13 Alternative investments
Due to the destruction in wealth brought about by the credit crisis, pension Iund managers
have a lot oI work to do in order to retrieve the situation Ior their now underIunded pensions.
With low interest rates and an uncertain inIlationary outlook, pension managers are
considering alternative Iorms oI investment. The attraction oI higher gains and the quest Ior
risk diversiIication has encouraged Iund managers to seek enhanced returns by investing in a
range oI non-traditional asset classes.
Developments in capital markets have provided new ways to manage risk and created
alternative asset classes that oIIer the potential Ior improved portIolio eIIiciency due to their
apparent low correlation with traditional investments. As pension Iund modelling has evolved,
there has been increased interest in the use oI alternative asset classes such as private equity,
hedge Iunds, and high-yield bonds, along with socially responsible investments.
In recent years there has been an explosion in the use oI derivatives by Iund managers in order
to reshape the riskreturn proIile and protect against downside market volatility or hedge
against currency Iluctuations. The advent oI such Iinancial instruments has allowed Iund
managers to alter radically their exposure to markets and currencies at relatively low costs.
The banking crisis has resulted in the deleveraging oI the market in terms oI Iund managers`
ability to borrow money to invest. The search Ior value has thereIore intensiIied with managers
seeking out alternative sectors such as inIrastructure, commodities, and real estate as homes Ior
investment. With the expected return on investment in alternatives currently standing at
between 10 20 per annum, there has been no shortage oI interested parties. However
investors need to develop expertise in the use oI hedging strategies in order to take advantage
oI such opportunities.
A} hedg|ng |nstruments
Hedging is the process oI reducing Iinancial risk within the portIolio. On a basic level a Iund
manager who takes a view that the market index is going to move downwards over a 3 month
period may decide to take the risk out oI the portIolio by locking into an index Iutures contract
sale, therein short hedging the Iund`. Taking such a position would mean that the Iund
manager sacriIices any Iuture gains should the index end the period above the 3 month Iutures
contract price.
In another situation a Iund manager may decide to avoid the risk oI the market going up by
locking into a 3 month index Iuture contracts purchase, known as a long hedge`, wherein at the
end oI the period he pays the amount and obtains the shares. Trading Iutures is a method oI
protection against market correction. Dealing in index Iutures is also a cheaper way oI trading
as opposed to actual physical share transactions.
1. Use of options
Options are Iinancial instruments that enable risk to be traded in either shares, currencies or
interest rates. A call option` is a contract giving its owner the right, but not the obligation` to
buy a given number oI shares at a Iixed price at any time on or beIore a given date. The buyer
pays a premium Ior this option to the seller who is obliged to provide the shares at the exercise
price should the buyer decide to exercise his option at any time up to the expiry date. Should
the share price on the expiry date be less than or equal to the original exercise price, the buyer
126
will decide to let the option lapse, therein IorIeiting the premium. The use oI options act as a
portIolio insurance in that it creates a limited downside Ior investors wherein the maximum
possible loss is the premium paid. On the other hand, buying a call option oIIers a higher
percentage proIit than investing directly in the shares and as such is similar to buying shares
partly with borrowed money.
A second type oI option is the put option` wherein the contract gives it`s owner the right, but
not the obligation, to sell a given number oI shares at a Iixed price at any time on or beIore a
given date. Market index options can be used by the pension Iund manager as a tool Ior
hedging against a market correction.
The use oI options is a good way to hedge contingent cash-Ilows, which may or may not occur.
They also provide a range oI hedging choices through the availability oI diIIerent exercise
prices. The use oI calls` and puts` when buying or selling shares at diIIerent exercise prices
oIIers the portIolio manager a combination oI choices with which to support the view on where
the market is going. Options also have the advantage oI not always requiring daily margins or a
bank line oI credit. The development oI the market in traded options has given rise to over the
counter` or OTC options. The OTC currency options are available Ior longer maturities and
thus more suitable Ior pension Iund managers.
2. Hedge funds
The deIinition oI alternative investment is constantly changing. Yesterdays alternatives quite
oIten become today`s mainstream; such is the case with regards hedge Iunds in the pension
Iund industry.
The use oI hedge Iunds is part oI a pension Iund managers` diversiIication strategy in terms oI
securing an eIIicient Irontier` to reduce risk in the overall portIolio. A primary advantage oI
using hedge Iunds is that investors can look towards an absolute return` on their investments in
that the targeted return on investment is met as a result oI hedging the market exposure oI
equities within the Iund so that it becomes market neutral. This is achieved through the use oI
long and short hedges with a view to reaching the required target oI return.
Although both the hedge Iund and alternative investments industry invest on an absolute return
basis, it is necessary not to conIuse the terminology with that oI guaranteed returns. Hedge
Iunds can, and do lose money, as witnessed by the poor perIormance oI Iunds throughout 2008.
The disappointing returns however do not detract Irom the demand Ior hedge Iunds as
diversiIiers in a pension portIolio. The task Ior the pension Iund manager is to select a suitable
hedge Iund that diversiIies the outcomes with a view to meeting the overall targeted return oI
the portIolio.
The most important aspect oI Iund management is to deliver value in terms oI risk and reward.
Hedge Iunds have been accused oI having a lack oI governance with regards the level oI risk
control and absence oI transparency on matters. This is predominantly the case in the Iund oI
Iund` Iormat wherein Iees are oIten layered onto clients at various points in the management
chain; oIten these Iees do not seem to be reIlected in the level oI risk reduction in terms oI
perIormance.
The use oI alternatives such as hedge Iunds can pose a challenge in terms oI their integration in
127
SAA models in that it is extremely diIIicult to match an absolute return` investment strategy
with long-term pension liabilities that are oIten indexed linked. It is perhaps best thereIore that
portIolio investment strategy should be separated into two distinct areas:
1. Assets that are being held to meet liabilities as they Iall due
2. Assets in the portIolio that are designed Ior a short-term return
Alternative Iunds that demonstrate a good value proposition` in terms oI risk control and Iees
are attractive to pension Iund managers. Widespread recognition oI the potential beneIits Irom
alternative assets has resulted in a variety oI vehicles being developed to allow institutions
access to these new` asset classes. However, the recent collapse in pension Iund values has
raised questions as to the value oI pursuing a diversiIication strategy when seemingly
diversiIied portIolio have Iailed to protect the assets oI investors
} Add|t|ona| asset c|asses
1. Commodities
Pension Iunds search Ior opportunities that would beneIit members over the long term whilst at
the same time balancing the risk oI the portIolio. As Europe holds its breath in anticipation oI
an inIlationary cycle Iund managers are becoming vigilant when it comes to equity-risk
premium. The volatility in the world stock markets is encouraging pension Iund managers to
consider asset classes across the investment spectrum. To this end managers are willing to
consider illiquid assets as they look Ior guarantees in return Ior locking up their capital. Real
asset classes in the Iorm oI commodities such as timber are now being selected as a long-term
inIlation hedge against rising prices.
2. Infrastructure
InIrastructure is emerging as a new asset class Ior pension Iunds to invest in. There are a
number oI diIIerent sub-sectors within the asset class, ranging Irom relatively saIe` social
inIrastructure projects with inIlation-linked cash Ilows, such as hospitals, to more speculative
investments, such as renewable energy projects where there is a higher degree oI operational
risk.
As the recession continues to bite into the public expenditure budgets oI many governments,
there is been an increase in the number oI inIrastructure projects approaching the marketplace
Ior Iinancing. InIrastructure is oI growing interest to pension Iunds because oI its long-term
predictable cash Ilows. Across the globe there are ongoing government plans Ior the
development oI inIrastructure. However, with state spending limited and debt more diIIicult to
access in the post-crisis environment, many managers believe there is an opportunity Ior the
private sector to get involved in the provision oI equity.
3. Private equity
Private equity involves the creation oI value through the provision oI risk capital and
management expertise to selected companies. Viable investment projects are selected by
private equity Iunds which exert control over the working capital invested in a business,
through Iocusing on elements such as accounts payable, account receivable and inventory
management. The control oI Iinances is oIten the key diIIerence between Iirms that survive and
128
those that do not. Private equity also concentrates on the value-add` that the operation
provides; this is achieved through a Iocus on strategic planning and positioning.
Fund managers pride themselves on delivering attractive returns on investment in times oI
adversity. However, as a result oI the ongoing Iinancial crisis, private equity Iunds have been
Iorced to consider restructuring in terms oI their Iees, proposed capital lock-up periods and
investment horizons. Since 1992, the private equity market has grown Irom $15bn to $1.5trn in
assets under management. In 2009 however, private equity Iunds raised only $150bn (t101bn)
in the primary market as the Iinancial crisis made investors more cautious. This compares to
$620bn raised in 2007 and an average oI $200bn Ior the last 10 years (Rohrbein 2009)
1
. The
association oI private equity with overloaded debt has damaged its reputation over the last 2
years and leIt investors with a bad image oI it as an alternative sector. Throughout 2009
investors questioned rates oI return and were more reluctant to commit additional capital to
ventures, seeking assurance that the private equity model actually works.
Prior to 2009 there was a lot oI leverage still available to private equity Iunds Irom the capital
market. Rising asset prices and an accommodating exit environment helped to generate healthy
returns Ior investors. Although the Iinancial climate has changed, there are still investment
opportunities Ior skilled managers to purchase quality operations at more attractive valuations
than ever beIore. To this end, judgement skills will be at a premium in terms oI the selection
and streamlining oI attractive businesses in order to add value and deliver returns.
As 2010 unIolds, there are indications that the private equity industry is showing signs oI
revival. Teather (2009)
2
reported that the private equity group APAX would be seeking an
initial public oIIering in 2010, which would be the Iirst private equity backed Ilotation oI this
kind since 2007. Khawar Mann, a partner at Apax notes that the Ilurry oI activity is evidence
oI the market returning, and adds that "the European debt markets have opened up over the past
Iew months, as they have in the US. We do see a lot oI opportunities, people still have high
expectations on price but leverage is starting to become available. We haven't been idle in the
past year; we have been tracking companies and waiting Ior the markets to open." The
increased visibility in earnings is bringing buyers and sellers closer together in terms oI pricing,
and breathing new liIe into the debt markets. However, it is likely that the days oI eight to 10
times leverage is a thing oI the past.
As private equity becomes a Iorce again there will be renewed Iocus on the operational
improvement oI companies, the generation oI new ideas, and the targeting oI shorter exit
strategies oI 3 to 4 years. As part oI this process it is likely that traditional private equity
investors will be extra vigilante when it comes to investing capital in companies with
underIunded pension schemes. Indeed, private equity groups are more inclined to close any
existing DB scheme linked to the business, as such schemes are considered a drain on Iinances.
1
Rohrbein, N. (Ed.). (2009, November 5). Private equitv fundraising falls in 2009. Retrieved Irom http://www.ipe.com//private-equity-
Iundraising-Ialls-in-200933191.php
2
Teather, D. (2009, December 9). Private equity shows signs oI new liIe. The Guardian. Retrieved Irom http://www.guardian.co.uk/////
private-equity-industry-new-liIe
129
4. Emerging markets
Globalization and the alignment oI business across continents have led to emerging markets
coming to the Iore as a mainstream asset class. Although emerging markets also suIIered as a
result oI the economic collapse, they have been the Iirst to attract capital as risk-seeking
investors returning to the market are seduced by their low cost production models and
prospects Ior sustainable growth.
The recovery in the emerging economies since the beginning oI 2009 reIlects a decoupling
process, as they become less dependent on the developed world Ior the purchase oI their
produce. This process has occurred as a result oI the widespread improvement in structural
and domestic balance sheet Iundamentals, which has allowed these economies to grow their
home markets more rapidly.
The emerging market index oIIers the investor an opportunity set Ior diversiIication into an
alternative asset class. Emerging market Iunds invest primarily in the regions oI Latin America,
Eastern Europe, Asia, Russia, India and China and currently represent 8-10 oI the MSCI
index. However, the economies in a GDP-weighted sense account Ior 25 oI the world
economy, which would suggest that the indices may be under-representing emerging markets
(Jones 2009)
1
. The statistics show that emerging markets accounted Ior 2 oI the indices 20
years ago; it is quite probable however that in 10 or 20 years time this Iigure may be 30, as
institutional investors become more attracted to the opportunities.
Emerging markets have a need to attract Ioreign capital in order to Ioster inIrastructure
development and economic growth. Stock-markets are regarded as one oI the most eIIicient
way oI raising capital; it is important thereIore that emerging economies develop their stock
exchanges in as structured a Iashion as possible Ior both Ioreign and domestic investors. In
order Ior these developing regions to become an attractive proposition to a pension scheme the
stock-markets need to oIIer diversiIied investment opportunities, as opposed to being
dependent on a small number oI sectors such as telecoms, or energy resources. As the risk
premium is high Ior investment into emerging market Iunds, there is a need Ior the Iunds to
develop their value proposition in a series oI stepping stones.
The process oI pension Iund asset allocation in terms oI emerging markets involves the
application oI investment rationale coupled with risk assessment. It is necessary that suIIicient
inIormation be available on an asset class Ior the manager to conduct an objective appraisal oI
the market potential and make robust investment decisions. There is also a need to gain the
support oI trustees when investing in emerging markets, as they are oIten considered heavily
weighted in risk seeking assets.
Improvements in macroeconomic Iundamentals, institutional structures and governance have
made the job oI analysing the level oI risk premium more systematic Ior Iund managers. The
aim is to create a clear, transparent methodology and to exercise good governance to ensure
that risks are correctly classiIied in order to attract capital. An extra level oI due diligence may
thereIore be necessary to calculate the operational risk to the pension Iund upon inclusion oI
the emerging market part oI the portIolio.
1
Jones, L. (Ed.). (2009, November 1). EM debt comes of age through crisis. Retrieved Irom http://www.ipe.com//debt-comes-oI-age-through-
crisis33125.php?articlepage1
130
Fund managers in their quest Ior alpha are turning to emerging markets as it becomes
increasingly diIIicult to secure attractive returns Irom developed markets. Emerging markets
however can present a contradiction in terms oI risk theory. Modern portIolio theory argues
that investors look Ior eIIicient markets and seek out the minimum risk position along the
eIIicient Irontier. In terms oI asset allocation, this would imply that developed market indices
should be chosen as opposed to ineIIicient emerging markets (Global Pensions 2009)
1
. With
growth now being driven by consumers in emerging economies, a certain degree oI global
rebalancing is taking shape as emerging markets rise up the pecking order in terms oI the
repositioning oI assets. Given that pension Iunds have longer term investment horizons, Iund
managers are showing increased willingness to consider the risk premium as being worthwhile
in terms oI the opportunity, and are thus prepared to adopt a more Iorward looking approach to
emerging markets in their asset allocation.
6} The susta|nab|e deve|opment sector as an asset c|ass
As Europe emerges Irom the economic crisis, politicians and organizations will be Iorced to
question the long held belieI that 'Iree markets know better'. At the G20 meeting in April 2009,
the European parliament resolved that the world urgently needs coordinated policies in order to
stabilise the economy against recession, counter climate change, and enhance sustainable
development. The key issue Ior the world economy as it attempts to move Iorward is how to
maintain an eIIective and eIIicient allocation oI resources. These objectives can not always
achieved by letting globalization have a Iree rein, or deregulating the Iinancial markets.
The BP debacle in the GulI oI Mexico has highlighted the need Ior socially responsible
ownership. Many UK pension Iunds have signiIicant equity and bond holdings in BP and are
thus exposed to the oil company`s plummeting share price. The reaction oI BP to the crisis has
raised concern over its long-term risk management policies and the tendency Ior the sector to
opt Ior low cost solutions when drilling Ior oil. This incident has raised awareness levels with
regards the need Ior pension Iunds to measure environmental, social and governance (ESG)
risks, and to assess their impact on investments. Investors as well as governments have a duty
to act as responsible owners, and scrutinize ESG risks with a view to ensuring that the
necessary measures are in place to reduce the probability oI such a crisis occurring.
The paradigm shift
The traditional asset classes oI equities and bonds have dominated asset allocation in pension
Iunds over the last 25 years. However all that is beginning to change with the emergence oI the
alternative energy sector and its sustained level oI growth. The potential risks associated with
climate change, coupled with evolving regulation, is leading to a paradigm shiIt in the business
models used Ior asset allocation. The public is becoming more aware oI the high stakes
involved in the protection oI the environment and its natural resources; the pension Iund
industry are thus attempting to seize the opportunity through the promotion and development oI
1
Global Pensions (Ed.). (2009, January 9). Targeting frontier markets . Retrieved Irom
131
a sustainable investment sector oIIering a range oI asset classes. Pichardo-Allison (2009)
1
observed that global asset managers had invested over US$300bn by 2009 in sustainable
investment assets in emerging markets, with $50bn oI assets being speciIically labeled as
socially responsible investment.
A structural shiIt is taking place as to how the issues relating to climate change are perceived
by investors. All oI this bodes well Ior the emergence oI sustainable development as an
important Iactor in asset allocation. As a result Green Iunds` have become increasingly
popular in recent years, driven by growing public demand and political awareness as well as
improving returns. Regulatory changes and the strengthening scientiIic evidence coupled with
the high media proIile oI climate change have resulted in investment in clean technology and
alternative energy becoming an attractive proposition.
Dignall (2009)
2
reports on a survey conducted at the end oI 2008 in the Netherlands on behalI
oI the Carbon Disclosure Project (CDP) highlighting that climate change is now perceived as
both a signiIicant risk as well as a potential catalyst Ior business opportunities. 'The concern
Ior CDP is that Iailure to address undisclosed exposure to climate change will lead to
substantially larger problems in the long term and bring down the value oI companies. As a
result, Dutch companies are integrating the value and cost oI climate change into long-term
strategies.
Sustainable asset management involves investment in assets that make a positive contribution
to the environment without compromising the needs oI Iuture generations. Risk management
involves the systematic assessment oI all external Iactors and their impact on a pension Iund; it
is thus necessary as part oI this process to consider the exposure that climate change poses to
long term asset value. This risk assessment process includes the consideration oI environmental
issues such as energy, pollution and waste. Investment strategies that incorporate eco-Iriendly
assets or eco-Iriendly technology are now being used by a number oI Iund managers to match
the long term liabilities oI pension portIolios with the sustainable economy oI the Iuture.
Legorano (2009)
3
draws attention to the plans oI the Danish state ATP scheme during 2009 to
invest up to DKK3bn (US$547m) in Iorestry through its new subsidiary ATP Timberland
Invest K/S. ATP's increased Iocus on climate-related investments included US$400m in
renewable energy technology. The investment targeted proven renewable energy sources such
as solar, wind and hydro, as well as emerging technologies including bio-Iuels and bio-mass.
The selected assets Ior investment were based in Spain, Germany and the UK, as the manager
believed that these countries oIIered the most attractive sources oI return.
1
Pichardo-Allison, R. (Ed.). (2009, April 1). Sustainable investments top $300bn. Retrieved Irom
2
Dignall, S. (Ed.). (2008, November 5). Dutch seek climate change opportunities . Retrieved Irom
http://globalpensions.com/owPage.html?pagegpdisplaynews&tempPageId824419
3
Legorano, G. (Ed.). (2009, March 20). ATP set to invest $500m in forestrv . Retrieved Irom
132
Clean energy is becoming a driver Ior perIormance in many industries including the automobile
sector. The shiIt in attitudes is helped by governments as they coerce companies into adopting
sustainable development strategies. Fiscal stimulus packages have been used as leverage in
order to promote policies designed to boost renewable energy and support Iirms developing
environmental technologies.
The Environmental Finance Magazine (April 2009)
1
highlighted proposals Irom the Norwegian
government that the state's $39 billion pension Iund should allocate $3 billion to sustainable
investments. At the same time, the Norwegian Iinance ministry proposed a major study on the
eIIects oI climate change on the Iinancial markets, and the greater integration oI social and
environmental considerations in the state pension Iund's management. A public announcement
was made that 'the investments will be aimed at eco-Iriendly assets or eco-Iriendly technology
that is expected to yield indisputable environmental beneIits, such as climate-Iriendly energy,
improving energy eIIiciency, carbon capture and storage, water technology, and management
oI waste and pollution. The aim oI the ministry is to develop an investment program that
spans across asset classes with varying scope in accordance with investment opportunities that
may present themselves at any given time.
As pension Iunds are major stakeholders in the largest companies oI the world, it Iollows that
they have a Iiduciary responsibility to examine all areas oI environmental risk surrounding their
investments. Fund managers are repositioning their asset allocation to move in line with the
public mood. However, Oakman (2008)
2
observes that those venturing into green investments
have not necessarily been Iocused on the risk side oI the equation, instead taking a more
thematic approach to the sector. She argues that 'the long term liabilities oI pension portIolios
will need to be met by the sustainable economy oI the Iuture. Sustainable development should
not be regarded as a source oI marginal alpha; moreover investment in clean technology and
alternative energy should be looked upon as the core oI a portIolio.
Pension Iunds have indeed an important role to play in the promotion oI sustainable
development. Although the Iund management industry has excelled in the Iinancial engineering
oI sophisticated products, the resulting high expectations oI return have led to unnecessary risk
being taking and as a result leIt many pension schemes underIunded. It is vital to society that
schemes look to adopt longer time horizons in terms oI investment in environmentally Iriendly
projects. However, the quest Ior short-term proIits can oIten have a negative inIluence on the
development oI social responsibility and environmental concerns. The situation is compounded
by the very nature oI pioneering companies in the sustainable development arena, in that they
are invariably small or mid caps in size and therein not able to tie-up capital Ior the long-term.
Recent changes in the US administration have created new impetus Ior sustainable asset
management. It could be argued thereIore that the time is now right Ior pension Iunds to
account Ior social responsibility and a long term commitment to the eco-industry in their
investment mandates.
1
Environmental Finance. (2009, April). Norwegian Iund proposes $3 billion green investments . Environmental Finance Maga:ine. Retrieved
Irom http://www.wbcsd.org//Search/.asp?typeDocDet&ObjectIdMzQxMTI
2
Oakman, E. (Ed.). (2008, November 26). A growing problem. Retrieved Irom http://globalpensions.com/
showPage.html?pagegpdisplaynews&tempPageId828361
133
Summary of research findings on pension fund asset allocation
When asked oI their plans Ior increased exposure to a range oI asset classes over the next 12
months the research survey Iound that over 20 oI pension Iunds intended to move more assets
into long term bonds (see Diagram 1). The two key reasons Ior such a strategic move would be
on the one hand to protect against volatile stock markets by having a more balanced portIolio,
whereas on the other hand, to reposition so that it is better place to meet its liabilities.
The quest to diversiIy risk was also reIlected in the proposed return to property. The property
market has had a signiIicant correction over the last 3 years to the extent that there now appear
to be opportunities with commercial and real estate being oversold in select areas.
InIrastructure also has looked an attractive sector to Iund managers with many projects now
being Iorced to approach the marketplace Ior Iinancing. The Iindings revealed that a buyers
market` is also developing in the private equity sector, with sellers presenting attractive
valuations to entice risk capital Irom pension Iunds.
Emerging markets are being considered as an alternative asset class as more business continue
to outsource activities to the developing world and their stock market values continue to surge
as a result. Hedge Iunds are also in demand by a number oI pension Iunds that wish to use an
insurance tool to protect against Ialling markets. Meanwhile commodities seem to be out oI
Iavor as Iund managers consider this sector being positioned at the lower end oI the cycle at
present. The survey revealed that Iew pension schemes appear to be attracted by the prospect oI
switching to environmentally Iriendly / green Iunds; they seem unconvinced that this is an asset
class that would deliver suitable returns on investment in the near to mid-term horizon. Given
that the Iuture oI the world economy is inextricably linked to the health oI the planet, it could
be argued that such a position is short-sighted. However, this reluctance may be simply due to
the Iact that it is the job oI Iund managers to obtain the greatest return Ior their pension scheme
members over an investment cycle, which invariably may not coincide with what is in the best
interests oI the planet.
Diagram 1: Projected pIans for asset aIIocation
Plan to increase exposure to the following asset classes in the next 12 months
c. Long term bonds 9 20.45
g. Property 8 18.18
f. Infrastructure 6 13.64
d. Private equity 6 13.64
a. Emerging Markets 6 13.64
h. Hedge funds 5 11.36
e. Commodities 3 6.82
b. Green funds 1 2.27
Total: 44
134
Chapter 14 Asset management strategy
In search of the holv grail- Alpha
The constantly changing environment is a signiIicant challenge Ior pension Iund managers in
their asset allocation strategy. The security selection process and timing oI investment decisions
become key aspects oI asset management. To achieve their objectives managers have a number oI
diIIerent investment strategies to choose Irom; their task is to squeeze the most returns Irom assets
over the investment period.
A} The quest for a|pha
European pension Iunds are increasingly directing their attention to controlling investment risk
and managing it more eIIiciently. A wider range oI asset strategies is being used to capture the
beneIits oI diversiIication with more emphasis being placed on active management (alpha) to
enhance returns and reduce emphasis on capturing market return (beta).
Alpha is a measure oI perIormance on a risk-adjusted basis that compares the excess return oI a
Iund relative to the return oI the benchmark index. The search Ior superior alpha strategies that
exploit market ineIIiciencies requires specialist Iund manager skills, and expertise in working
with limited data or low liquidity levels. As such, alpha invariably represents the value that a
portIolio manager adds to or subtracts Irom a Iund's return in terms oI a positive or negative
perIormance.
1. Passive management strategy
A passive investment strategy oIten involves the use oI a market index Iund, or market segment, as
determined by a benchmark. Donaldson (2008)
1
advocates that indexing strategies hold the majority
majority oI their assets at their market weight with index managers believing that any exploitable
inIormation about an asset`s Iuture perIormance is smaller than the expense and Iriction costs oI
active management. Donaldson adds that 'indices can be used as a benchmark representing
market movements, or as a reIerence oI risk Ior a group oI assets. Some Iund managers may
opt to steer close to the index as it minimises the risk oI underperIorming the index benchmark.
It also provides a measure Ior analysis oI the stocks perIormance in the market, and the
associated risk in terms oI volatility and correlation.
2. Active management strategy
The shiIting sands oI economics, markets, liabilities, and regulation provide managers with an
opportunity to engage in dynamic asset allocation strategies. SuccessIul active management
strategies out-perIorm the market through eIIective stock selection and periodic switching oI
assets over the economic cycle. This approach is practised by skilled Iund managers whose job
is to select stocks with a view to outperIorming a benchmark index. This task oI balancing risk
and reward expectations is achieved in accordance with the Iund's goals and investment
horizons.
1
Donaldson, S. (Ed.). (2008). Implementing strategic asset allocation. Retrieved Irom http://www.ipe.com//.php
135
Such a specialist approach to Iund management may include investment in the emerging
market sector, or alternatively the trading oI Iutures and options which will allow the manager
to exploit any miss-pricings between securities. In addition, certain sectors such as small-cap
stocks oIten outperIorm the broader market over the short term, thus oIIering an opportunity to
surpass the benchmark iI included in the portIolio.
An actively managed portIolio achieves superior perIormance through taking advantage oI market
ineIIiciencies; the real test however is whether such perIormance can be sustained over the longer
term. It is necessary to build into the equation the costs involved in pursuing an active strategy in
terms oI perIormance Iees Ior the Iund manager. These costs make it more diIIicult to match the
market return. Problems invariably arise when Iund managers take on additional risk in order to
compensate Ior such costs.
} Yarket t|m|ng versus t|me
Active Iund managers try to outperIorm the market by getting the timing right in terms oI
trading in and out oI assets classes, as opposed to holding select securities over a period. The
basic premise oI this approach is that should an asset class such as equities appear cheap at a
given time in an economic cycle, then the pension Iund portIolio should be overweight in that
particular sector. The objective thereIore is to take advantage oI the peaks and troughs
experienced during these cycles.
Alternatively Iund managers may preIer to hold on to asset classes, in which they have Iaith,
Ior the longer term. This philosophy is based on the belieI that in times oI market
turbulence, strong asset classes are like boomerangs in that they always come back, and that
the generation oI investment returns is an issue oI time and not timing`. This type oI Iund
management approach is based on the assumption that markets behave in an eIIicient
manner. Finding an actively-managed Iund that consistently outperIorms the market can be
equated to the proverbial search Ior a needle in a haystack`. As such, it could be argued that
the pension Iund manager should chose indexing as an optimal strategy
Core / satellite approach
As an alternative to the adoption oI passive or active management strategies, some pension Iund
managers opt Ior a combination oI core assets and secondary or satellite holdings. The core /
satellite concept involves a number oI satellite holdings positioned around a core investment
component. The objective oI such a strategy is to enhance long-term perIormance by
complementing market-weighted indexes with specialist, actively managed Iunds.
Core holdings generally consist oI a broad range oI diversiIied assets. They are normally in the
Iorm oI a Iund that is weighted in the large-cap companies oI a market index, which acts as an
anchor Ior the overall investment plan. The core component may consist oI sector or country
weighted indices and may also involve investment in the Iixed interest sector. One over-riding
Iactor oI the core holdings is that they more oIten than not involve a low-cost structure that
provides the best chance oI delivering market returns.
Meanwhile, the satellite approach is used to exploit opportunities outside the broad market index or
to explore investment options that deviate Irom the characteristics oI the overall market. Secondary
sectors may include emerging markets or a Iocus on themes such as energy, agriculture or
136
commodities. A Iund manager may choose to rotate the satellite component oI the portIolio as
inIormation is gained on market direction over the short term.
Legorano (2009)
1
advocated that 'the core / satellite approach to asset allocation is a cost
eIIective way oI selectively accessing alpha. Such a strategy allows sponsors to match the skills
oI an active manager, specializing in a given sector or class, with the core part oI the portIolio
in order to manage the Iund`s risk eIIectively. The approach may also be more cost eIIicient Ior
schemes in that high Iees may only be absorbed on a portion oI the portIolio with the core part
mirroring an index benchmark.
It is important Ior sponsors to be aware that stock-markets can go down as well as up; as such it
must be recognised that the use oI satellites in a pension portIolio can interIere with the realisation
oI goals and objectives iI the outcomes Iall short oI expectations (Donaldson 2009)
2
. Donaldson
observed that combining core and satellite components oIIers the opportunity Ior the pension Iund
manager to Iind a suitable mix in the allocation strategy between the relative perIormance
predictability oI the core portIolio and the potential Ior outperIormance oIIered by targeted Iunds
(see Diagram 14.1 below).
Diagram 14.1: Core / sateIIite approach to asset management
Source - IPE.com 2008
Applying a core / satellite approach to asset allocation strategy helps to diversiIy portIolio risk. The
strategy also has an impact on the portIolio`s tracking error against a broad market benchmark. The
tracking error is the diIIerence between the return on the index Iund and the return on the index.
The higher the percentage oI the investment portIolio a Iund manager allocates to satellite Iunds,
the greater is the potential Ior the total portIolio to outperIorm the underlying broad-market
benchmark.
The core / satellite approach to portIolio management has come under scrutiny as a result oI the
Iinancial meltdown. Legorano (2009)
3
argued that 'in the past, the core, or passively managed
1
Legorano, G. (Ed.). (2009, April 9). Changing vour approach . Retrieved Irom http://www.globalpensions.com/pensions///approach
2
Donaldson, S. (Ed.). (2008). Implementing strategic asset allocation. Retrieved Irom http://www.ipe.com//.php
3
Legorano, G. (Ed.). (2009, April 9). Changing vour approach . Retrieved Irom http://www.globalpensions.com/pensions///approach
137
part oI the portIolio, Iocused on traditional underlying securities oI bonds and equities.
However, the last Iew years have witnessed a new trend towards the use oI derivatives and
assumption oI counterparty risk as part oI the core portIolio. The search Ior alpha by Iund
managers throughout 2008 and 2009 saw satellite Iunds taking additional risk that did not result
in excess returns. The problem was exacerbated when diversiIication strategies also Iailed to
protect the portIolio Irom Ialls in the stock-market. The underperIormance oI satellites has led
to pressure being applied by Iund sponsors Ior the use oI benchmarking with regards certain
assets. Fund managers are now being asked to incorporate aspects oI market inIormation, such
as threats or downgrades, into the selection process oI satellites so as not to be over reliant on
market Iundamentals.
There is always potential Ior return in the marketplace, with distressed assets such as real estate
oIIering value. Pichardo-Allison (2009)
1
notes that the economic slowdown resulted in many
Iund managers opting to rebalance their core/satellite allocation Irom a 60-40 to a 40 60
position. However, to be in a position to take advantage oI a depressed situation, the pension
Iund manager needs access to Iresh capital; a Ieat that may be diIIicult to achieve iI pension
contributions by both the sponsor and employees are being curtailed.
The real impact oI Iailed strategy is Ielt by pension Iunds when they are Iorced to liquidate the
satellite positions when the market is at a low point in order to generate liquidity to maintain
Iuture liabilities. The level oI disillusionment with the market may lead to less adventurous
managers reverting to passive Iund management through the selection oI more traditional assets
or index tracking Iunds.
In Sweden, the national AP pension system reported an underlying shiIt towards passive
management and a more traditional strategic asset allocation. Hasslev (2009)
2
observed that
Swedish schemes were experiencing a return oI the generalist` approach as they place greater
emphasis on a top-down analysis as opposed to the bottom-up stock picking method applied by
specialists. It is oI course always easier to make comments aIter the event, but in hindsight a
top down` approach oI investing in Iixed income securities would have been successIul in
avoiding the collapse oI pension Iunds during 2008.
The restructuring oI the AP schemes has resulted in the reduction oI active risk management
and with it the quest Ior alpha. This change has also been supported by Swedish clients, who
have requested that the active mandate have a tracking error oI 3 basis points around the return
oI the benchmark index, as opposed to the tracking error oI up to six basis points that was
previously in place.
In general, it is not unusual Ior mandates to be awarded Ior a set number oI years to a Iund
management group, with a targeted benchmark return oI a perhaps 1 3 above a given index.
The mandate may be constrained or unconstrained depending on the level oI control desired by
the company trustees. It may also be a long only mandate restricting the type oI asset classes
selected.
1
Pichardo - Allison, R. (Ed.). (2009, April 9). PH&C dives into European small-cap. Retrieved Irom
2
Hasslev, P. (Ed.). (2009, April 2). Swedish AP svstem put to the test. Retrieved Irom http://www.globalpensions.com/pensions///ap-test
138
Summary of research findings on pension fund investment strategy
39 oI those managers surveyed apply an active management strategy with a view to out-
perIorming the market over the economic cycle (see Diagram 14.2 below). Opportunities have
been abundant Ior such a strategy oI eIIective stock selection throughout 2009 due to an oversold
market. As a result many sectors have rallied and paid dividend to those who either had
calculated the undervalued position oI certain sectors, or were adventurous in their asset
allocation policy.
Almost 32 oI pension schemes preIerred to minimize risk by pinning their Ilag to the market
index in a passive approach to asset allocation strategy. Meanwhile 12 chose a core / satellite
approach to investment strategy by balancing core index or sector weighted Iunds with
specialist actively managed Iunds in their quest Ior alpha.
The Iindings also revealed that pension schemes seem to be turning their attention to liability driven
investment strategies with almost 10 oI respondents Iavouring an approach geared to meeting
Iuture commitments to plan members.
Diagram 14.2: Investment strategies empIoyed by pension fund managers
Type of investment strategy employed by pension fund manager
b. An active management
strategy
16 39.02
a. A passive management
strategy
13 31.71
c. A core/satellite approach 5 12.20
d. A liability driven
investment strategy
4 9.76
e. Other 3 7.32
Total: 41
139
Chapter 15 Risk management and pension funds
'Markets can remain irrational far longer than vou or I can remain solvent (John Mavnard
Kevnes)
At times over the past Iew years it seemed that the markets had become so good at 'parcelling
risk' that they almost convinced themselves that the risk didn`t exist. Some oI the main
protagonists acted as though they could actually parcel` the risk and dispatch it to outer space
and be done with it; unIortunately risk management is not so simple. However, despite the
turbulent times that pension Iunds have experienced it is important that managers do not lose
their appetite Ior risk. No risk means no reward; risk should thereIore not be abolished as a
strategy Ior the accumulation oI wealth.
A key task Ior pension Iunds is to try and manage risk as eIIectively as possible. One oI the
limiting Iactors with risk management is that there is oIten an over-reliance on historical data
among decision makers which only oIIers partial guidance Ior the Iuture. It is important that
risk is managed in real time in order to respond to Iast-changing markets. Sheen (2009)
1
highlights a survey oI over 180 DB plan sponsors conducted by Mat LiIe in Jan 2009 which
revealed that pension Iund sponsors tend to Iocus on the most easily deIinable risks at the
expense oI those more diIIicult to model and measure. Findings oI the survey suggested that
managers assessed risks individually as opposed to taking a more comprehensive approach.
Sheen observed that perIormance ranked as the most signiIicant Iactor with regards Iund
management Ior 54 oI respondents, and that investment return, asset allocation and the under-
Iunding oI liabilities were viewed as more important than longevity, mortality and early
retirement risk.
Pension Iund management is becoming more challenging as a result oI demographic changes,
the regulatory environment and market volatility. It is important thereIore that measures such as
value at risk` are not too narrow in their deIinition oI risk. Nothing is 100 per cent certain; a 95
per cent statistical probability is indeed a signiIicant threshold, however it still leaves us with a
5 per cent possibility that things will go wrong. The essence oI risk management is to have a
strategy in place that allows the manager to be wise beIore the event and not aIter it occurring.
To this end the emphasis is on the need Ior a chieI risk oIIicer` (CRO) to track all knowable
risks, including concealed risks across the risk spectrum. ThereaIter it is up to the CRO to
communicate and report in simple terms what they are doing to management.
A} 6urrency and portab|e a|pha
The impact oI currency exposure in a pension Iund is becoming an increasingly important
Iactor in the investment equation. Should the pension Iund manager invest in Ioreign assets, the
1
Sheen, A. (Ed.). (2009, January 27). Sponsors focus on easv risks . Retrieved Irom
140
level oI exchange rate diIIerence between the asset purchase price and the price when the asset
is eventually sold or traded, will have a substantial eIIect on the capital gain.
Pension Iund managers need to consider currency risk and returns within the context oI total
portIolio risk/return and the separation oI alpha and beta. Investors are beginning to use
currency not as an overlay strategy but as a separate source oI alpha, and are increasingly
seeking to appoint managers to run a portion oI the Iund in both developed and developing
currencies.
Using currency to gain alpha returns is a specialised skill set that has developed into an integral
part oI enterprise risk management strategies. Institutional investors can not rely solely on
quantitative models when considering risk return strategies; it is indeed almost impossible to
assess probability using quantitative models in times oI uncertainty. As a result, applying the
wrong equation can have Iatal consequences to the value oI the portIolio. Fund managers also
examine qualitative Iactors in their currency strategy in order to diIIerentiate themselves Irom
other managers. These Iactors include the nature oI the business, the choice oI systematic or
discretionary styles oI management, and the turnover along with the average holding period,
and application oI risk controls.
1. Currency mandates for the institutional manager
Currency managers can be hampered in their ability to add value to clients by the terms oI the
mandate which governs the use oI currencies within the pension portIolio. Fund managers may
push Ior a more active currency mandate in an eIIort to generate returns or recoup losses
absorbed Irom the equity markets over the last Iew years. Should a pension Iund consider using
an active manager, it is important that the manager`s brieI allows them as much room as
possible to trade in the Iull universe oI currencies.
The Iinancial tsunami has Iorced pension Iund managers to regularly rebalance their Ioreign
currency exposures in order to avoid Ialling short oI targeted returns. The process oI currency
management is a much more complicated task than simply trying to manage to a benchmark.
To adequately address the risks implicit in Ioreign currency exposures, pension Iunds need to
manage mid-month market exposure risk, liquidity and market impacts, along with collateral
and counterparty risks. During 2008 and 2009 Iund managers witnessed great movements in
currency valuations that Iorced them to deviate Irom their strategic targets in Ioreign currency.
Large swings in trading between the pound sterling and other major currencies throughout the
course oI 2008 materially aIIected the cash position oI many pension Iunds at a time when
liquidity was at a premium.
2. Reduction in currency volatility
In times oI low volatility, investors look Ior alpha in terms oI currency risk management.
However, the recent high levels oI volatility in currency markets has resulted in the need Ior
Iund managers to seek hedging strategies as a way oI reducing risk and dragging down returns.
Pichardo-Allison (2009)
1
observes that many institutional investors already hedge out the
currency risk Irom Iixed income investments because the risk oI taking a Iall as a result oI
currency Iluctuations is much higher than with equities. A prime example oI such a correction
1
Pichardo - Allison, R. (Ed.). (2009, April 9). Reducing currencv volatilitv. Retrieved Irom http://globalpensions.com/
141
is visible in the pension portIolio oI UK based clients, who experienced a signiIicant
devaluation oI the pound sterling Irom 2007-9 and hence a drop in the value oI their assets set
against other major currencies. It is prudent thereIore Irom a medium term perspective to hedge
the Ioreign equity and bond exposure oI client holdings in pension Iunds.
Currency is oIten regarded as a zero sum game` over the long run, in that it is primarily the
base currency that an individual will identiIy with in terms oI where they intend to spend their
retirement; it still however represents a degree oI noise that should be ironed out oI the equity
portIolio. Adopting a hedging strategy may involve a certain degree oI risk to the cash-Ilow in
that iI the risk that is being hedged does not materialize, or reverts against the position taken, it
can be a costly exercise. Investment opportunities and risk reduction strategies are oIten two
sides oI the same coin when Iaced with volatile currency markets. However, it could be argued
that iI pension schemes don't possess a strong governance Iramework, in terms oI the necessary
expertise to systematically evaluate risk, they should perhaps stick to plain vanilla assets like
bonds and equities
} The econom|cs of pens|on fund management
1. Deflation v inflation
Fund managers are concerned with removing the unrewarded risks oI interest rate and inIlation.
DeIlation occurs when the annual inIlation rate Ialls below zero as a result oI a sustained
decrease in the general price level oI goods and services. One oI the Ieatures oI the Great
Depression in the 30`s was the emergence oI deIlation as a result oI unprecedented levels oI
debt caused by excess leverage. An interesting development in the current investment climate is
that governments are becoming major players` in the arena as they seek to introduce
mechanisms to stabilize GDP and control inIlation. A major side-eIIect however to the
Iinancial crisis is that oI stagnation caused by the lack oI growth and demand in the economy.
It is important that the pension industry is not a bystander to the situation and thus adopts a
proactive stance on the issue oI inIlation / deIlation. Since the events oI 2008 many managers
have been bracing themselves Ior the reoccurrence oI a depression, and thus have given
consideration to what asset allocation strategy they should employ in order to ensure the
pension Iund against deIlation.
Masih (2009)
1
argued that iI interest rates remain close to zero, the economy will be Iaced with
a situation oI unconventional easing wherein companies struggle to generate a healthy stream
oI proIit margins. This corrosive Iorm oI deIlation would lead to the majority oI equities being
viewed as an unattractive asset option. In such a scenario pension Iund managers would
consider the selection oI equities that deliver dividends, and intermediate- to longer-term bond
Iunds in order to protect the purchasing power oI investors. It must be noted that although long
Treasury bonds perIormed well during 2008, the perIormance during 2009 was not the same as
the investment climate changed. The world is now two years into this crisis, and the jury is still
out as to whether the economy going Iorward is more likely to experience inIlation as opposed
to deIlation
The current eIIects oI deIlation can be interpreted as a deleveraging story. As such, the
1
Masih, R., & Steer, C. (Eds.). (2009, March 9). Plan sponsors weaving through peril. Retrieved Irom http://www.pionline.com
142
challenge is Ior managers to decide how to reassess valuations oI individual stocks and bonds,
and to look strategically at the rerating system, and the downgrading oI companies and
countries simultaneously. The objective oI the Iund manager should thereIore be to create
inIlationary asset classes in the downdraIt oI deIlation. Such assets can be bought in the broad
commodity and real asset classes.
Equities, along with alternatives asset classes such as private equity and long-biased hedge
Iunds suIIer in a deIlationary environment. However, the opposite is the case in an inIlationary
environment wherein the central banks practise quantitative easing and public sector borrowing
which results in a devalued currency. In such an environment private equity in particular would
Iind any Iunds it has borrowed inIlated downwards in terms oI the real value oI money that
they have to repay.
With inIlationary and deIlationary Iactors playing an ever increasing role in the valuation oI
assets, managers need to be more dynamic in their strategic assumptions. Asset allocation may
have to be revisited more Irequently than on an annual basis in order to best calculate the mean
variance dispersions and their eIIects on the portIolio over time.
2. Interest rate risk
The need to meet pension scheme Iunding levels has resulted in a greater emphasis in
managing assets more eIIectively. Once again it is important to emphasize that the role oI the
Iund manager is to ensure that liabilities are met in order to honour the commitment to
beneIiciaries in the Iuture. To meet this objective, managers need to scrutinize interest rate risk
as well as equity risk. The parameters oI activity in terms oI interest rate risk-management will
be covered in the mandate awarded to the pension Iund manager by the scheme sponsor.
With the structure oI a pension Iund`s liabilities constantly changing, there is no guaranteed
way oI Iully hedging interest rate risk. Interest rate changes can trigger risks that may reduce
the returns on cash deposits and Iixed income securities. It is important thereIore Ior the
manager to be aware oI volatile interest rate patterns and yield curve shapes.
A major responsibility oI the Iund manager is to liaise with Iinancial institutions which act as
intermediaries in the investment oI pension contributions. One oI the many tasks is to take a
view on interest rates in terms oI the maturity oI treasury bonds that are selected as investment
vehicles. The manager also has to consider whether to alter the maturity date oI the bond or be
on the look out Ior more attractive yields on a daily basis. Large savings can be obtained Ior the
sponsor iI the Iund manager gets the positioning right. However a wrong decision may result
in the creation oI a hole in the projected Iunding plans.
When interest rates Iall sharply, pension schemes become Iocused on their balance sheets and
growth. As part oI the risk return equation the Iund manager will consider what proportion oI
the assets should be invested in Iixed interest securities with the aim oI providing a degree oI
guaranteed return. The manager will look at a series oI bonds with diIIerent coupon rates and
durations to IulIil this obligation. An appropriate asset mix needs to be determined on issues
such as short-term versus long-term bonds and Iixed rate versus Iloating rate commercial paper
and bonds. The Iund manager may have to consider any trade-oII in balancing the certainty` oI
interest rates through Iixed rates with the maximization oI interest rates through Iloating rates.
143
Problems arise when interest rates rise or Iall in response to external inIluences caused by
economic and political events. As a result the manager must be vigilant in order to maximise
the returns on the Iunds assets and achieve the goal oI Iully Iunded pensions. II the view is that
short term interest rates will be higher than longer term rates Ior the Ioreseeable Iuture, the
manager is more likely to preIer investment in commercial paper over a 5 year period rather
than longer duration bonds. The manager must also consider whether to alter the maturity oI the
investment or the Iorm oI the interest payment on a daily basis. With the current Iinancial crisis
there is greater pressure Ior Iund managers to manage their portIolio more dynamically and
eIIiciently. There is a lot at stake in terms oI proIit should the pension Iund manager be in tune
with the market and call the Iunding situation correctly.
3. Effects of inflation and interest rates on pension funds
The blame Ior the widening UK pension Iund deIicit can not be laid solely at the door oI the
stock-markets. Pension Iunds can no longer be run on the premise oI equity-market risk with
the principal driver being the perIormance oI equities over liabilities. The problem with such an
approach is that it oIten ignores interest-rate and inIlation rate risks in the underlying portIolio
oI liabilities. It may be preIerable to approach the problem Irom an ALM perspective. To
achieve this, Iund managers strive to pick alpha Irom one market and combining it with beta
Irom another market.
A pension model presented by XaIinity (2010)
1
on UK pension scheme liabilities suggested
the Iollowing:
The yield on bonds has continued to Iall, with AA yields tumbling to 5.5 as opposed
to 6.7 at the start oI the year. The reduction oI 1.2 will increase pension Iund
liabilities by around 22;
Long-term inIlation is around 0.5 higher than in January, thus increasing inIlation
linked liabilities by up to 10;
A two year increase in the liIe expectancy oI Iuture pensioners will increase the year-
end liabilities by 6.
It is becoming clear on analysis oI the latest Iigures that the increase in asset values has been
oIIset by increases in pension liabilities as a result oI Ialling discount rates. The high bond
yields that originally masked the problem during the early days oI the economic crisis have
dwindled away leaving Iund managers with increased inIlation expectation and holding out
Ior sustained asset growth in order to clear pension deIicits. Based on the model assumptions,
XaIinity predict that the total UK corporate pension scheme deIicit will increase Irom the
300 billion Iigure calculated as oI the end oI 2009 to 452 billion by the end oI 2010. This is
indeed an issue oI major concern to the industry, employers and in particular pension Iund
beneIiciaries.
1
XaIinity. (2010, April). Corporate UK Pensions - Model Solution. Abstract retrieved Irom
http://www.xaIinity.com/osites/Consulting//Solutions/Solutions-Example.aspx
144
6} The use of bonds |n pens|on fund management
It is necessary to examine in greater detail the role oI the bond market in helping pension Iunds
meet their liabilities to members when they Iall due. Investment in a bond results in the pension
Iund being guaranteed a Iixed interest payment or coupon on certain speciIied dates in the
Iuture. Upon maturity the principal amount is also repaid to the pension Iund. This allows the
Iund manager to budget Ior a particular yield Irom the bond investment.
In an example oI a 5 year bond, with a value oI 100 t and carrying a coupon oI 10, an
investor expecting a 9 return would be prepared to pay 103.89 t per 100 t nominal as
Iollows:
.
+
(
.
)
+
(
.
)
+
(
.
)
+
(
.
)
= 1u x u.917 + 1u x u.842 + 1u x u.772 + 1u x u.7u8 + 11u x u.6S
= 1uS.89
The Iigure is arrived at by discounting expected cash Ilows by the required interest or discount
rate oI 9. As the coupon oI the bond is higher than the going interest rate, investors are
prepared to pay above par Ior the bond.
1. Factors affecting bond price sensitivity
Bonds respond to interest rate changes on two key variables:
The coupon rate
Bond maturity
In the example above, the coupon on the bond will remain Iixed at 10 irrespective oI any
market interest rate change. However the price oI the actual bond will change in association
with the interest rate moves and in line with the number oI years to maturity oI the bond.
RutterIord (1996) highlighted the Iollowing principles which explain how bond prices respond
to changes in interest rates:
1. Bond prices move inversely with interest rates
The basic bond valuation equation is:
Piesent value of a bonu =
Cash
(
1 + i
)
The price oI a bond is equal to all promised cash Ilows discounted to the present by the yield to
maturity oI the bond. The higher the yield or rate oI interest r in the above equation, the
smaller the price or present value. As a result, iI required yields on bonds rise, bond prices will
drop.
145
2. The longer a bonds maturity, the greater will be its change in price Ior a given change in
interest rates
3. The sensitivity oI a bond`s price to a change in interest rates increase with maturity, but
at a decreasing rate
4. The lower the coupon rate on a bond, the greater will be the change in price oI the bond
Ior a given change in interest rates
5. Bond prices move inversely with interest rates
6. The longer a bonds maturity, the greater will be its change in price Ior a given change in
interest rates
Longer term bonds are more sensitive to interest rate changes. As the interest rate Ialls the price
oI bonds rise. A pension Iund manager expecting interest rates to rise may preIer to hold the
longer term bond. However iI interest rates are expected to drop, the Iund manager may preIer
to hold a shorter term bond as its price would Iall less on a percentage basis.
7. The sensitivity oI a bond`s price to a change in interest rates increase with maturity, but
at a decreasing rate
8. The lower the coupon rate on a bond, the greater will be the change in price oI the bond
Ior a given change in interest rates
2. Development of immunization strategies
Given the continuous Iluctuation oI interest rates, the Iund manager is Iaced with the challenge
oI ensuring that the liabilities towards plan members in terms oI their pension are met. The
concept oI duration was developed in 1938 by ProIessor F.R. Macaulay to solve the problem oI
liability management. An additional step in addressing the issue was put Iorward by F.M.
Redington in the 1950`s with his use oI duration in the development oI immunization
strategies. The use oI duration and immunization strategies help pension providers meet their
liabilities in that policy holder premiums would be invested in Iixed income securities that
would have the same present value oI that oI the liabilities.
3. Duration
A bond can be considered as a set oI cash Ilows; therein the Iurther away the cash Ilows and the
larger the distant cash Ilows, the more volatile the bond. Duration is regarded as a means oI
measuring the volatility oI a bond by combining the eIIects oI maturity and coupon into a
single number. Duration is thus a measure oI a bond`s average maturity in that it reIlects the
amount and timing oI a bond`s cash Ilows (RutterIord 1996)
1
.
Duration is calculated as the sum oI the present values oI each oI the cash Ilows (expressed as a
percentage oI the price) weighted by the maturity oI each oI the cash Ilows as Iollow:
B =
1
P
1 X
CF
(
1 + i
)
+ 2 X
CF
(
1 + i
)
+. . . n X
CF
(
1 + i
)
1
RutterIord, J. (1996). Duration and Immunisation. In Corporate Financial Strategv (pp. 15 - 21). Walton Hall, Milton Keynes: The Open
University.
146
4. Bond duration calculation
A Iour-year 10 coupon bond yielding 9 would have a duration oI 3.5 years, as calculated in
Table 15.1 below.
TabIe 15.1: CaIcuIation of a bonds duration
1 2 3 4 5
Cash flow vear Cash flow Present value of
cash flow
Present value as
of price
Time weighted
component of
duration
t t
1 10 9.17 8.89 0.089
2 10 8.42 8.15 0.163
3 10 7.72 7.48 0.224
4 110 77.93 75.48 3.019
103.24 100.00 3.495
Duration is used as a measure oI the average liIe oI a bond and also gives a measure oI how
much the price will change in response to a given change in interest rates. The Iormula used is
as Iollows:
uP = -B X P X
ui
(
1 + i
)
where
r the interest rate required on the bond, known as the yield to maturity
P the price oI the bond
D the duration oI the bond
Dr the change in the interest rate oI the bond
dP the change in the price oI the bond
A pension Iund manager would thus calculate the impact oI a 1 interest rate increase on a
bond with a duration oI 5 years, a price oI t100 and a yield to maturity oI 10 as Iollows:
uP = -S X 1uu X a foui yeai bonu piiceu at t 1uu with both a coupon iate anu maiket
inteiest iate of 1u%anu a uuiation of S.49S yeais
u.u1
(
1 + u.u1
)
= -4.S4
This would result in the price oI the bond Ialling by 4.54 to t 95.46
147
It Iollows that when interest the rates change Irom the initial required yield, the price oI the
bond is Iorced to change, given that the coupon payments are Iixed.
5. Use of bonds to meet liabilities
A Iund manager with liabilities oI t 100 m Ialling due in 4 years may chose to invest in two
separate bonds with a view to meeting commitments. Assuming that interest rates are at 10 at
the time, the assembled portIolio may appear as Iollows:
Bond A a Iour year bond priced at t 100 with both a coupon rate and market interest rate oI
10 and a duration oI 3.495 years
Bond B - a twelve year bond priced at t 100 per t 100 nominal with both a coupon rate and
market interest rate oI 10 and a duration oI 7.495 years
The proportion oI the portIolio to be invested in Bond A is 87.5, with the balance oI 12.5 in
Bond B.
The present value oI the amount to be invested today in order to achieve t 100m in 4 years with
a discount rate oI 10 is calculated as Iollows:
Pv =
(
.
)
=1uu X u.68Su
= t 68.Su
The bond portIolio will thus be constructed oI:
Bond A: 0.875 X 68.3 t 59.8 million
Bond B: 0.125 X 68.3 t 8.5 million
Table 15.2 displays the perIormance oI the portIolio in 4 years time given that the interest rate
remains at 10.
TabIe 15.2: Pension portfoIio after 4 years assuming 10% yieIds
Bond A Bond B Mix of bonds A and B
t t t
Bond price aIter Iour years
100.00 100.00
Coupon income
40.00 40.00
Reinvested coupon income
at 10 p.a.
6.41 6.41
Total
146.61 146.61 100.00
The value oI the portIolio is thus:
( . . . . )
= t 1uum
The process oI immunization protects the pension Iund against Iuture interest rate Iluctuation.
For example, a dramatic Iall in interest rates Irom 10 to 5 as a result oI economic concerns
would have the Iollowing impact on the portIolio as shown in Table 15.3 below.
148
TabIe 15.3: Pension portfoIio after 4 years assuming 5% yieIds
Bond A Bond B Mix of bonds A and B
t t t
Bond price aIter Iour years
100.00 117.73
Coupon income
40.00 40.00
Reinvested coupon income
at 5 p.a.
3.10 3.10
Total
143.10 160.83 99.24
The value oI the portIolio is thus:
( . . . . )
= t 99.24m
Despite a signiIicant Iall in the value oI interest rates the pension Iund manager will have been
able to meet over 99 oI the liabilities. Through the process oI immunization, the selling price
oI the bond has risen and in so doing oIIset the Iall in reinvested income.
Immunisation strategies are oIten practised in bond portIolio management. In the example
above it can be seen that although Iuture cash-Ilows do not exactly match, their average
duration does. As a result, the asset side immunises` the eIIect oI interest rate changes on the
liability side.
6. Pension funds and zero-coupon bonds
Zero- coupon bonds make no coupon payments during their liIetime and have the distinct
characteristic oI their duration being always equal to their time to maturity. This makes the
zero-coupon bond ideal Ior use in the immunization process oI pension Iund management.
Long term zero-coupon bonds in the Iorm oI Treasury bills` would be purchased by the Iund
manager and either held to maturity or sold on a secondary bond market prior to maturity. The
interim sale oI the bond would generate either a gain or a loss depending on how prices have
changed since the original date oI purchase.
7. Yield curves
The interest rate on investment in bonds varies in accordance with their duration and is known
as the yield to maturity`. The relationship between yields and maturity dates Ior a set oI
similar bonds can be can be shown on a yield curve` at a given point in time, as in Diagram
15.1.
Diagram 15.1: Interest rate yieId curve
149
The yield curve is also known as the short term structure oI interest rates. A positive or
normal` yield curve occurs when short-term yields are higher than long-term yields; this
results in the curve sloping upwards.
Because a bond oIten has more than one yield to maturity, spot rates are used to represent the
true underlying term structure oI interest rates. The spot rate is an interest rate Ior a loan made
now repaid in one lump sum at the time oI maturity. The average oI the underlying spot rates oI
a bond provide us with the internal rate oI return oI the bond.
Zero coupon bonds create a set oI regularly spaced single payment bonds, with a yield to
maturity that is equal to the spot rate with the same maturity. This implies that spot rates can
be simply read oII Irom the yields to maturity oI zero coupon bonds.
8. High yielding bonds
The two main tasks oI the pension scheme manager are to manage the capital in the Iund and
also the interest rate risk. The term structure oI interest rates allows the pension Iund manager
to take a view on short term versus long term investment in order to meet the liabilities towards
the scheme members.
At present pension Iunds have a great opportunity to step into the void oI the illiquid banking
sector and purchase some company bonds. This would have a twoIold eIIect oI helping
reintroduce conIidence in the economy, whilst at the same time extending credit lines to a part
oI the industry which is currently Iloundering. Pension Iunds may be attracted to high yielding
bonds issued by reputable companies seeking to raise capital Ior their ongoing projects.
However there is always the need Ior caution as such instruments may have undesirable risk
properties and therein weaken the ability oI the Iixed-income benchmark to protect the Iund
capital in periods oI recession.
0} The ro|e of 'swaps' |n pens|on fund management
1. Mitigation of interest rate exposure
Given that interest rate policy and duration have a large inIluence on the ability oI the pension
Iund to deliver to its beneIiciaries, the industry is beginning to reIocus attention on the Iunding
status oI pension schemes. Ross (2007)
1
argues that interest rate risks are the key Iactor in
maintaining adequate Iunding levels. In his analysis oI the two golden periods Ior pension
Iunds oI 1978-1981 and 1993-2000, Ross observed that during the Iormer period the Iunding
status oI pension schemes was bolstered by an interest rate increase Irom 7.5 to 15,
whereas in the latter period the rise was attributed to excess returns on equities.
The research also revealed that healthy equity gains during the period Irom 1984-1992 were
cancelled out by Ialling interest rates which brought about a negative net eIIect to the Iunding
status. The economic turbulence experienced Irom 2000 - 2004, and 2008 to the present has
1
Ross, P. (2007, January). Investment and Pensions Europe. Creating an optimal portfolio to fund vour pension liabilities, pp.57-68.
150
resulted in European governments adopting a policy oI low interest rates in order to stimulate
growth; this has had a disastrous eIIect on the Iunding status oI pension Iunds and led to
deIined beneIit schemes requiring increased contributions and in some cases reduction oI the
pension promise to beneIiciaries.
Recent research by Towers Watson (2010)
1
highlights that pension Iund diversiIication into
alternative assets including derivatives continued throughout 2009 as schemes tried to hedge
their positions in order to be able to service liabilities. However, the Iund manager is oIten
presented with a problem in terms oI the duration oI bonds. The mismatch between the duration
oI bond assets held and liabilities may be the result oI a low supply oI bond issues at long
maturities. Fund managers use this shortage oI supply as reason to pursue an active
management strategy by using swaps`.
2. Interest rate swaps
One approach to reducing interest risk exposure is to lengthen the duration oI the bonds being
held in the portIolio to ensure that they match the corresponding liabilities. Increasingly
however, Iund managers are opting Ior the use oI swaps as a tool to hedge against interest risk
sensitivity.
The Iund manager will decide on an appropriate mix oI short-term and long-term investment in
bonds and consider whether these investments will be made at a Iixed or Iloating interest rate.
The use oI interest rate swaps` oIIers the manager greater Ilexibility in maximizing interest
rate returns. The manager would use interest rate swaps to limit or manage the Iunds exposure
to Iluctuations in interest rates. Investment into a bond can be taken out at either a Iixed rate or
a Iloating rate at the outset and at any time swapped Irom one rate to the other whenever the
interest rate view changes or to an interest rate schedule that is appropriate to their needs. This
ability to swap between Iixed and Iloating rates allows the Iund manager to separate the cost
decision Irom the risk decision.
The interest rate swap is a liability management product that allows Iund managers to exchange
one steam oI interest payments Ior another with diIIerent characteristics. Although the parties
agree to exchange streams oI interest payments over time, no principal amount is actually
exchanged, either initially or at maturity. The interest payments are based on the underlying
notional principal amounts (RutterIord 1996)
2
. Such a situation arises when a pension Iund that
has invested in Iixed rate debt, seeks to transIorm the interest rate Irom Iixed to Iloating rate at
a given time by Iinding a counter party who wishes to reciprocate.
A basic example oI an interest rate swap in practice is as Iollows:
Party A agrees to pay Party B periodic Iixed rate` payments in exchange Ior periodic variable
rate` payments using LIBOR as the reIerence interest rate base. Each party sets up a separate
1
assets///.pdI
2
RutterIord, J. (1996). Interest Rates and the Corporate Treasurer. In Corporate Financial Strategv (pp. 38 - 47). Walton Hall, Milton Keynes:
The Open University.
151
swap with a Iinancial intermediary bank. Party A, which holds Iloating debt, agrees to pay the
bank a Iixed rate oI 8.65 and the bank pays Party A a Iloating rate oI LIBOR 55bps
(0.55). Party B which holds Iixed debt agrees to pay the bank a Iloating rate oI LIBOR
70bps (0.70), and the bank pays Party B a Iixed rate oI 8.5 (see Diagram 15.2 below). The
Iixed rate is reIerred to as the swap rate. In this example both parties by entering into an
interest rate swap can IulIil their desired objectives.
Diagram 15.2: Interest rate swaps
The intermediary bank is compensated in both cases. On the Iloating rate side it receives
LIBOR 70bps and pays LIBOR 55bps, a spread oI 0.15 or 15bps. It also receives Iixed
interest oI 8.65 whilst paying 8.50, a spread oI 0.15. In return Ior matching the two
parties the bank has charged a total spread oI 30bps.
Advantages oI swaps Ior pension Iunds
Swaps are Ilexible and can be structured to match cash Ilow obligations with regards
pension liabilities
Transactions can be reversed by entering into a reverse swap with a new counterparty.
This may allow proIits to be realized iI interest rates have moved since the original
swap transaction.
Transactions can be reversed at any time because oI the size and liquidity oI the interest
rate swap market.
Although the greatest potential Ior asset growth Ior pension Iunds oIten lies in equity
investment, it provides little protection against interest rate movements or inIlation. The search
Ior solutions to interest rate exposure has led to the development oI the interest rate swap and
derivative markets as tools Ior mitigating risk inherent in pension liabilities. As a result pension
Iund managers employ a range oI hedging strategies which may include the adoption oI both
long` and short` positions in the same asset class or market.
The liabilities oI the pension scheme are constantly shiIting in value as cash-Ilows are linked to
interest rates and therein the movement in yield curves. Derivative instruments such as hedge
Iunds and interest rate swaps are now being widely used by Iund managers as tools Ior the
mitigation oI risk. Investment strategies pursued by DB schemes are oIten similar to those used
in long-short hedge Iunds. Such schemes are usually structured with a combination oI equities
and actively managed bonds with a view to meeting liabilities. The strategy employed is to
adopt a short` position in long dated bonds and to go long on equities.
151
pension liabilities
swap transaction.
rate swap market.
151
pension liabilities
swap transaction.
rate swap market.
152
Maloney (2009)
1
outlines the argument in the chart on the leIt oI Diagram 15.3 below which
shows a typical proIile oI projected cash-Ilows Irom a DB pension Iund. Active cash-Ilow is
related to members still working Ior the company sponsoring the DB scheme, deIerred cash-
Ilow is related to those who have leIt the sponsoring employer but have not yet retired, and
pensioner cash-Ilow is related to those who have retired Irom the sponsoring employer.
A portIolio oI real / nominal zero coupon swaps is used as a hedging tool. The chart on the
right displays a portIolio wherein the present value oI liability cash-Ilows is shown as a short,
or negative position, and the hedge portIolio is shown as a set oI positive zero coupon bond
redemptions. Cash-Ilows are discounted with an appropriate zero coupon yield; as the yield
curve moves, liability values move accordingly. II liabilities have been hedged correctly, then
assets will move in line with changes in the discount rate used to value liabilities, and Iunding
will be stable.
Diagram 15.3: Use of swaps for meeting IiabiIities
Source: Maloney 2009
1
Maloney, M. (2007). Managing an unwanted risk for defined benefit pension plans (Mercer, Ed.). Retrieved Irom http://www.mmc.com//
Managingriskpensions.pdI
153
Maloney considers three diIIerent applications oI swaps in the diagram below as Iollows:
Diagram 15.4: Different appIications of swaps
Source: Maloney 2009
In the Iist instance, swap agreements are employed using counterparties via an investment
bank. The second approach is to appoint an outside bond manager who would enter into swap
agreements on behalI oI the pension Iund. Alternatively, bond assets could be transIerred into a
so called bucket Iund` wherein a predetermined set oI Iixed durations may be achieved that
match the clients` liability proIile.
A major reason Ior using interest rate derivatives to immunize portIolios is that they have a
more liquid market and do not require wholesale changes in existing asset allocation structure.
An additional attraction Ior the use oI such instruments is that they have to be Iunded in their
entirety up Iront. Both interest rate swaps and swaptions are used to help hedge risk by pension
Iund managers. The decision whether to choose swaps or swaptions is interest rate dependent,
in that swaps can hedge most oI the interest rate risks in an environment where interest rates are
relatively constant; whereas swaptions are preIerred in low interest rate environments as they
protect the upside potential.
At the Bankpension DC scheme in Denmark, the head oI investments LeiI Hasager revealed
that they manage their liabilities via Iorward receiver swaptions, which allows the Iund
manager the Iacility to enter into an underlying swap, receive a Iixed rate and pay a Iloating
rate (Roehrbein 2010)
1
. Although the Iund pays a premium Ior the purchase oI the swaption, it
is rest assured that it will not run the risk oI suIIering substantial declines in asset values iI
interest rates go up. The liabilities oI the Bankpension Iund are currently hedged at a 75 ratio;
the management has adopted a strategy oI being opportunistic when interest rates rise by
increasing the hedge slightly and rebalancing the ratio once again as interest rates Iall.
1
Roehrbein, N. (Ed.). (2010, April 1). How do vou manage vour liabilities? Retrieved Irom http://www.ipe.com//do-you-manage-your-
liabilities34553.php
154
3. Longevity swaps
Moss (2009)
1
argues that a route Iorward Ior DB pension schemes is to oIIload longevity risk
by the purchase oI swaps or bulk annuities, wherein the Iund agrees to make a series oI known
payments to the insurer, in exchange Ior a series oI payments dependent on how long each
scheme member lives. This means the pension Iund is eIIectively placing a cap on the
corresponding liability to each member. However, the scheme retains ownership oI its assets.
Such a move would be in contrast to a conventional buyout wherein assets are transIerred
wholly to the insurer and the scheme's investment perIormance thereaIter is linked to insurance
company returns. Although the current underIunding crisis in the industry may prevent
schemes Irom oIIloading their risk all at once, there is interest in reducing risk incrementally
over time and thence a growing attraction Ior the use oI longevity swaps.
An example oI longevity swaps in action was witnessed recently with the UK motor and
household insurer RSA. In the middle oI 2009 RSA secured Iuture payments to more than halI
the employees in its Iinal salary pension scheme through a 2bn pension portIolio insurance
deal with Goldman Sachs (Inman 2009)
2
. This move allowed RSA to eliminate the risk oI
having to increase Iunding on 1.9bn oI its pension liabilities and thus deliver a boost to
earnings Irom 2010 onwards. Due to the restructuring oI the pension scheme, 55 oI payments
to pensioners in the Iinal salary scheme were to be covered by derivatives. This restructuring oI
the portIolio has reduced risks in the Iund through the sale oI equities and purchase oI inIlation
swaps with a view to hedging the risk oI rising inIlation. The new strategy also aims to hedge
the risk oI increases in liIe expectancy, along with corporate bond spreads and inIlation, whilst
at the same time maintaining the level oI investment returns.
The pressure to minimise costs oI increasing liIe expectancy, Ialling investment returns and the
costs oI inIlation-prooIing has taken its toll on the RSA pension scheme in the UK. As a result
it has been Iorced to close its Iinal salary scheme to new members and shiIted current
employees to a career average scheme. Inman noted that the liabilities oI the RSA pension
scheme at the time were equal to the company's 4bn market capitalisation; the scheme trustees
claim that the transition will reduce the risk impact oI the UK pension scheme on the group's
results and balance sheet.
Summary of research findings on the consideration of de-risking strategies
Given an ageing population and its impact on the liabilities oI pension Iunds, respondents were
asked to conIirm which de-risking strategies, iI any, they would consider employing over the
Iollowing 12 month period. 39 oI pension scheme management voiced a preIerence Ior using
swaps` as a mechanism Ior matching cash Ilow obligations in terms oI pension liabilities.
Longevity insurance as a means oI mitigating risk was preIerred by 18 oI those surveyed,
whilst 14 would consider a pension buyout` wherein schemes would seek to oIIload risk by
1
Moss, G. (Ed.). (2009, June 4). Longevitv swaps buv now while stocks last? Retrieved Irom http://www.ipe.com//swaps-buy-now-while-
stocks-last31918.php
2
Inman, P. (2009, July 14). RSA in 2bn deal to secure staII pensions RSA in 2bn deal to secure staII pensions , The Guardian .
Retrieved Irom http://www.guardian.co.uk//insures-staII-pension
155
transIerring their assets wholly to a third party who thereaIter would be responsible Ior the
scheme's investment perIormance and subsequent returns (see Diagram below). It is signiIicant
however that 29 oI schemes had not considered any oI the three selected de-risking strategies.
Diagram 15.5: De-risking strategies
De-risking strategies considered in the last 12 months
b. Swaps 11 39.29
d. None of the above 8 28.57
c. Longevity insurance 5 17.86
a. Buyout 4 14.29
Total: 28
156
Chapter 16 Review of the funding status of DB plans
A} Pens|on p|an fund|ng and the 't|me va|ue of money'
A DB plan promises to provide its participants with a predetermined level oI retirement
beneIits in the Iuture. As the market value oI these assets Iluctuates, the plan's assets and
liabilities do not always match and as such have an impact on Iunding Ior Iuture obligations.
It is the role oI the actuary to manage the plan's Iuture pension liabilities. This is achieved by
addressing the time value oI money` through the use oI a discount rate to ascertain the net
present value oI Iuture cash-Ilows. The discount rate thus reIlects the Iuture value oI money,
and incorporates both an adjustment Ior inIlation, and a risk-adjusted return on the use oI the
money. The standard discount rate used by institutions is the 30 year Treasury bond rate; it is
both a conservative Iigure and is risk-Iree.
As a rule oI thumb` it is estimated that a change in the discount rate oI 1 (eg Irom 6 to 5)
will result in a rise in the present value oI Iund liabilities oI 8-12. Small diIIerences between
the company`s cost oI capital and the IFRS discount rate can thereIore have a devastating eIIect
on the liabilities Ior large DB pension schemes and may even lead to their closure.
A deIined-beneIit plan is said to be Iully Iunded when the aggregate return oI the portIolio
matches the target return needed to honor the liabilities. To achieve this objective, the plan
sponsor adopts a strategic asset allocation and investment policy that guides the plan's
investment oI Iund contributions across various asset classes over time.
Pension Iunds can Iind themselves in a position oI being temporarily underIunded as a result oI
cyclical market movements. When a portIolio experiences a sustained equity market decline
coupled with low interest rates the pension Iund will witness a signiIicant increase in the
present value oI its Iuture liabilities. The consequences oI such a situation may include an
adverse eIIect on the organization's balance sheet, disruption oI an organization's cash Ilow,
and unwanted scrutiny oI the organization by regulatory agencies and investors.
Rules governing funding levels
Those companies that provide deIined-beneIit plan`s to their employees Iind that they are under
a legal obligation to make up any shortIall oI the underIunded plan. This shortIall has to be
Iunded out oI earnings and is oIten an unIoreseen drain on cash-Ilows and Iuture investment-
related expenditure.
The rules governing the Iunding levels oI pension schemes vary signiIicantly between countries
and between diIIerent types oI pension Iunds. Funding levels are oIten measured in accordance
157
with local accounting rules which are speciIic to Member States. Henderson (2009)
1
reports
that Belgian local pension plans have asked Ior more time to meet Iunding recovery plans. The
industry-standard short time Irames are currently placing undue pressure on executives and
company sponsors to meet Iull Iunding targets, particularly in cases where Iunds have
obligations to meet guaranteed returns. Henderson quotes Karel Stroobants, a Belgian pension
consultant, in his comparison oI pension plans in Belgium and Britain: 'the UK has an
advantage in that the permitted recovery period Ior Iunds is much longer; the UK system is also
supported by a pension protection Iund that acts as a saIety net Ior schemes. Decisions in the
UK are based on a covenant between the scheme managers and the sponsor; quite oIten a
strong covenant results in a longer recovery period being extended to the pension plan
managers. Stroobants notes that these two elements would be useIul in Belgium, where they
do not use an insurance-based pension model and where the covenant is reviewed only once a
year, with the expectation that Belgian schemes regain their Iully-Iunded status over the
shortest period oI time.
In the UK, the Pensions Regulator has relaxed its rules to assist pensions recovering during
the Iinancial crisis. This allows DB schemes to take longer than the regulatory 10 years to
reach Iull Iunding status. Belgian pension plans on the contrary have just 18 months to
exercise recovery; thereaIter they are obliged to Iund any shortIall in Iunding through
increased contributions.
A recovery plan should take into account the strength oI the scheme sponsors and the cash-
Ilow situation oI the pension Iund. Stroobants argues that iI the duration oI the scheme is
over an extended period, and there is evidence oI a solid governance structure along with
positive cash-Ilows, then there should be no reason Ior not granting a recovery period oI 5-7
years. He added that in a situation where the cash-Ilows are negative, a shorter recovery
period oI three years should be considered.
An underIunded pension scheme is a business problem. By assessing the Iunding status oI their
organizations' plans, Iund managers can uncover any Iunding deIiciencies and identiIy
appropriate steps to ensure the plans provide the promised retirement beneIits.
All parties should be kept inIormed oI any remedial action that might improve the plan's
Iunding ratio. It is important to periodically examine the plan's current strategic asset allocation
and investment policy to ensure that it is capable oI generating a return that allows it to meet its
liabilities and that expectations Ior Iuture returns are not overly optimistic. The geographical
distribution oI assets has taken a more global path in recent years as pension Iunds seek to
spread their risk; as a result, the currency exposure oI assets under management has become an
increasingly important Iactor. In order to cope with the wider dimensions oI international Iund
management it has become necessary to consider the addition oI alternative investments such
as hedge Iunds or real estate, or reclassiIy asset classes Irom large cap to small cap sectors with
a view to meeting the goals oI the scheme.
Attention also needs to be given to the Iees charged by third parties such as vendors, trustees,
managers, and consultants, so as to ensure that they are reasonable and competitive. Excessive
service charges are a needless drain on pension Iunds and have a signiIicant impact in terms oI
1
Henderson, J. (Ed.). (2009, August 25). Consultant calls for longer Belgian recoverv time. Retrieved Irom http://www.ipe.com//consultant-
calls-Ior-longer-belgian-recovery-time32533.php
158
loss in perIormance when extrapolated over the term. Fee structures thereIore need to be clear
and transparent; moreover the sponsor has to Ieel that the Iund manager is actually adding
value in return Ior Iees that are charged.
} The f|nanc|a| cr|s|s and the |mpact on fund|ng |eve|s
The market turmoil has aIIected pension Iund asset allocation decisions and the associated risk
management strategies employed. Indeed, the market has a very short memory when it comes
to making the right call` in terms oI positioning; one oI the most important lessons to be
learned in trading is that the market does not respect reputations, it makes them. It is necessary
thereIore that Iund administrators are prepared Ior all eventualities. The Iunding level and
general Iinancial health oI pension schemes is becoming oI particular issue to trustees and
sponsors alike. DiversiIied portIolios, risk management, and governance, have all become
crucial to the ability oI sponsors to deliver to scheme members.
The shiIt by many pension Iunds during 2009 / 10 to Iixed income warranted signiIicant merit
over the period; however with markets in a constant state oI Ilux, this positioning may not
necessarily be the answer that pension scheme trustees were hoping Ior, due to the wide
divergence between managers` recent and likely Iuture perIormance within the bond space.
There is also concern over the level oI toxic assets` that hedge Iund managers may be exposed
to. This problem raises the issue oI how to value assets in a Ialling market. Along with the
concerns surrounding liquidity oI investments and associated redemption issues, pension plans
have been Iocused on a mark to market` valuation oI assets. Marking to market is diIIerent to
marking to model, which can be a subjective and oIten unrealistic Iorm oI valuing assets,
particularly when volatility can have a short term negative impact on asset values. The main
problem however with using the marking to market approach to asset values is that it
exacerbates the underIunding problem Ior pension schemes, and may result in regulators
imposing corrective legislation that may have negative connotations Ior the scheme over the
longer term.
The market correction and the ensuing low interest rate environment have had a signiIicant
negative impact on the Iunding levels oI schemes in the UK and Ireland. Germany and the
Netherlands have Iared better in terms oI maintaining Iunding above the regulatory solvency
levels. In the short term many schemes have applied corrective action to address the
underIunding issue. In some instances the sponsors have increased their contributions, and in
others there has been a temporary reduction or suspension oI contributions.
The push by the European insurance industry to have a level playing Iield in terms oI the
pensions sector using a market-based approach in accordance with the Solvency II principles oI
transparency and disclosure, has had considerable support. However many DB advocates have
criticized such strategies on the grounds that a market-based approach oIten leads to greater
risk taking in order to meet Iuture pension Iund liabilities.
Risk management is the key Iactor in DB pension schemes meeting commitments to their plan
members. 'The process involves the measurement and assessment oI pension Iund risks and the
design, monitoring and revision oI the Iund parameters in terms oI contributions, beneIits and
investments, in order to address these risks in line with the Iund objectives (Blome et al
159
2007)
1
. DB schemes are mainly exposed to the risks oI market volatility, inIlation and
longevity. Plan members, Ior their part, are also exposed to their scheme being underIunded
and therein run the risk oI being unable to collect on the pension promise.
Blome argues that risk management strategies should have the Iollowing goals:
Minimizing the pension cost to contributors.
Minimizing the risk oI beneIit cuts to beneIiciaries
The aim oI the IORP Directive was to bring together the diverse regulatory authorities oI
Member States under a single umbrella to create a Iramework that would satisIy plan sponsors
and plan members, both active and retired. However, signiIicant losses experienced by pension
Iunds have leIt companies with large holes in their Iunding levels and contributed to Iears that
many will not be in a position to make the required pension contributions.
1. Underfunding issues in Ireland
In Ireland there were calls Ior urgent reIorm in 2008 as oIIicial estimates suggested that three
out oI Iour DB plans could now Iail to meet the Iunding standard, compared to just one in Iour
at the end oI 2006 (Dignall 2008)
2
. Ireland currently has almost 100,000 schemes with a
combined total oI more than 800,000 members, oI which 66 are DB and 34 are DC
schemes.
The situation has deteriorated even Iurther in the last year with Iindings by Mercer Consulting
that 8 out oI 10 DB schemes in Ireland now have Iunding problems, and that halI oI all
schemes have been required to submit recovery plans to the Pensions Board by the end oI June
2010 (Williams 2010)
3
. Mercer`s research reveals that 15 oI Irish DB schemes are likely to
wind-up because oI Iunding diIIiculties.
Poor investment returns, declining asset values and longer liIe expectancy have put pressure on
employers to increase contributions in order to meet the discontinuance Iunding standard.
However, the consultancy warned that as many as 10 oI DB schemes are planning to reduce
accrued beneIits with a view to improving the Iunds` long-term outlook. Although employers
appear to be reluctant to take such drastic measures to retrieve the situation, in many cases
Iunding diIIiculties are so stark that a wind-up is being presented as the only alternative option.
Proposals have been presented to the Irish regulator Ior a suspension oI the requirement Ior
immediate Iunding should a company scheme experience diIIiculty in meeting the actuarial
1
Blome, S. et al (Ed.). (2007, May). 'Pension Fund Regulation and Risk Management. Results from an ALM Optimisation Exercise`, OECD
Working Papers on Insurance and Private Pensions, No. 8. Retrieved Irom http://www.oecd.org////.pdI
2
Dignall, S. (Ed.). (2008, December 8). Funding rules need urgent reform. Retrieved Irom
3
Williams, J. (Ed.). (2010, March 11). Underfunding prompts Mercer to question the future of Irish pensions. Retrieved Irom
http://www.ipe.com//prompts-mercer-to-question-the-Iuture-oI-irish-pensions34329.php?sunderIunding
160
Iunding requirement, in return Ior a commitment oI the sponsoring employer to continue the
scheme.
As a result oI the current economic climate, some employers are being Iorced to explore the
limits oI their obligations in terms oI deIerring or minimizing increases in cash contributions
and to identiIy non-cash alternatives that may be more acceptable to their business. Solutions
being pursued include a push by one in Iour pension Iunds to encourage employees to increase
their contribution rate by a minimum oI 10. In addition, up to 15 oI schemes are expected
to shiIt Irom DB to deIined contribution in the Iuture, with members then receiving payment
Irom both schemes.
Active members, or those still working Ior the company sponsoring the DB scheme account Ior
51 per cent oI scheme members in Ireland. The remaining balance is made up oI 30 pensioners
and 19 per cent deIerred members or those who have leIt the sponsoring employer but have not
yet retired.
The requirement to meet Irish Pension Board standards in respect oI scheme solvency is a
signiIicant Iactor in decisions being taken by scheme sponsors. Mercer called on the Pensions
Board to extend the deadline Ior recovery plans beyond the proposed deadline oI 30 June 2010,
to allow all proposals to consider the impact oI the new National Pensions Framework,
launched in March 2010, and the introduction oI auto-enrolment Ior anyone over 22 Irom 2014.
It cautioned that the changes, with also included an increase in retirement age to 68 by 2028,
would signiIicantly impact any plans.
2. Underfunding issues in the UK
The UK has adopted a Ilexible approach to Iunding with no statutory minimum requirement.
As mentioned previously, the UK system is also supported by the Pension Protection Fund
(PPF) which provides insurance against sponsor insolvency.
The April 2010 Iigures Irom the UK PPF 7800 index, which monitors the Iunding level oI UK
pension Iunds, revealed that the total deIicit oI all UK private sector DB schemes had reached
210bn, or a Iunding level oI 83 (Stewart 2010)
1
. Despite a recovery in UK equity returns oI
nearly 40 in the previous year, Stewart reports that DB pension liabilities have grown even
Iaster and thus widened the pension deIicits.
The PPF was originally set up as a pension scheme liIeboat Ior employees oI corporate
bankruptcies. The downturn has led to an increase in insolvencies and therein a queue oI
schemes waiting to be rescued. There is however concern that the rising number oI pension
corporate Iailures could overwhelm the PPF.
1
Stewart, N. (Ed.). (2010, May 11). UK funding update. April put DB schemes into deficit. Retrieved Irom http://www.ipe.com//Iunding-
update-april-put-db-schemes-into-deIicit34911.php?sppI
161
3. Underfunding issues in the Netherlands
In contrast to the UK, the Dutch system has no insolvency insurance protection such as the
PPF; it does however employ strict minimum Iunding rules that require a cover ratio oI 105
oI the pension Iunds liabilities in nominal terms.
Throughout 2009, many employers based in the Netherlands had to rethink their policies
towards asset allocation. Under Dutch pension rules, all pension schemes with pension Iund
coverage ratios below 105 were obliged to Iile recovery plans with the pension regulator, De
Nederlandsche Bank (DNB), by 1 April 2009 detailing how they planned to restore solvency.
In May 2010, DNB reported that the nominal cover ratio Ior pension Iunds improved Irom 95
to 109 on average during 2009, while their combined assets have increased by t86bn to
t663bn (Preesmen 2010)
1
. However, despite average returns oI 15.9, pension Iunds are still
short oI their peak position in 2007, when their Iunding ratio was 144 on average, and their
assets totalled t690bn, according to the DNB. The regulator's annual report also showed that
Dutch schemes` real cover ratio rose Irom 71 to 81 on average last year, aIter a high oI
108 in 2007;
4. Underfunding issues in European multinationals
Stewart (2009)
2
brings attention to a report by Alpha Value, the independent equity research
group, which emphasized that 31 major European Iirms have underestimated their pension
obligations by a Iigure oI more than 40. The organization claimed pension deIicits were
underestimated by around t300bn at the 430 listed European companies researched by
AlphaValue, as employers minimized Iuture salary increases and maximized discount rates.
The analysis revealed that conventional estimates oI pension deIicits Ior the 430 companies
surveyed as oI the end oI 2008 grew by 22 to t280bn. However the research argued that an
additional t300bn, or 9 oI total shareholders' equity has gone unrecognized as a result oI the
use oI higher discount rates in the Iunding level calculations.
Alpha Value noted that while average wage inIlation rate Iell Irom 3.7 to 3.6 during 2008,
the average discount rate increased Irom 5.38 to 5.57. They added that although the 30bp
improvement in the spread may look insigniIicant "it is not when applied to t1.1trn oI
obligations. A rough indication is that this 2008 'spread' saved European corporations about
t51bn in extra provisioning".
1
Preesman, L. (Ed.). (2010, May 20). Cover ratio of Dutch funds recovers to 109 DNB. Retrieved Irom http://www.ipe.com//cover-ratio-
oI-dutch-Iunds-recovers-to-109-dnb35447.php?snetherlands
2
Stewart, N. (Ed.). (2009, November 16). Pension deficits underestimated bv European firms. Retrieved Irom http://www.ipe.com//deIicits-
underestimated-by-european-Iirms33278.php
162
The most underestimated obligations Ior Iunded pension schemes included the Iollowing
organizations outlined in Table 16.1:
TabIe 16.1: Underestimated pension obIigations by European major firms
2008 Pension obligation
Funded obligation Recalculated Underestimate
Lloyds Banking Grp 18,375 32,617 14,242
RBS 32,653 45,966 13,312
British Airways 15,068 25,580 10,512
Siemens 22,654 32,742 10,088
Barclays 18,221 27,928 9,707
Royal Dutch Shell 37,119 45,958 8,838
HSBC 16,955 25,202 8,247
Glaxosmithkline 14,457 22,443 7,986
BT Group 39,212 46,986 7,774
ING 14,219 21,787 7,568
Electricite de France 16,939 23,002 6,063
Source: All information supplied by AlphaValue (2009) and all figures in fm.
Pension regulation has continued to tighten across Europe as legislators seek to saIeguard
occupational pension beneIits Ior current and Iuture pensioners. There is indeed a lot at stake;
however pension Iunds have had to work harder than ever to meet the challenges presented by
regulators in terms oI Iunding levels.
The last 18 months have witnessed strong volatility in pension Iund liabilities as a result oI
collapsing asset values coupled with changing interest rates. With risk seemingly on constant
replay in the minds oI investors and the threat oI inIlation on the horizon, the task is thus Ior
Iund managers to allocate risk eIIectively.
6} 6ompar|son of assets w|th ||ab|||t|es
Towers Watson (2010)
1
gave consideration to the evolution oI deIined beneIit assets in
comparison to that oI liabilities Irom 1998 - 2009 and examined the asset/liability ratio Ior each
market as demonstrated in Diagram 16.1 below.
1
assets///.pdI
163
Diagram 16.1: DB asset/IiabiIity indicator - gIobaI basis (P13)
Percent change Irom 31 December 1998 (in USD)
Source: Towers Watson and various secondary sources
DB assets only within asset totals
UK assets exclude Personal and Stakeholder assets
US assets include IRAs in all periods
Brazil and South AIrica are not considered in this analysis
Mortality changes are not incorporated in these Iigures
*P13 Australia, Brazil, Canada, France, Germany, HK, Ireland, Japan, Netherland, South AIrica, Switzerland, UK, US
Globally, assets in pension Iunds experienced the same crisis as institutions in European
countries:
Global pension Iund balance sheets recovered in 2009 aIter having suIIered a signiIicant
correction in 2008, when Iunds saw their assets shrink amid the Iinancial crisis and
liabilities surge during the same period;
Compared to its 1998 level, the global asset/liability ratio has deteriorated by 25,
despite the recovery during 2009;
On an individual market basis, asset/liability levels rebounded in 2009 aIter having
plunged in 2008. However levels are still signiIicantly lower in most countries than they
were in 1998, with the UK in particular showing a ratio drop oI 43.
164
Chapter 17 Asset liability management and liability driven
investment
'If vou must plav the game, decide upon three things at the start. the rules of the game, the
stakes, and the quitting time` (Chinese proverb)
The majority oI the literature looks at portIolio management Irom an asset management point
oI view, as opposed to an assetliability management (ALM) or liability driven investment
(LDI) perspective. ALM is a tactical Iorm oI asset allocation applied as a portIolio insurance`
which essentially seeks to secure a minimum value Ior the pension Iund at all times in order
that liabilities can be met. The process itselI is an opportunity Ior the manager to identiIy,
understand and assess the universe oI risks which the scheme may be exposed to. ALM builds
on the riskreturn approach oI portIolio management through the development oI strategies that
reduce pension Iunding volatility by aligning investments more closely with plan liabilities. As
such, it is an ideal model Ior use in pension Iund management.
A} The move to ALY and L0| strateg|es
With pension Iunds witnessing a balance sheet recession as a result oI the Iinancial crisis, the
Iocus is moving now towards ALM rather than proIit maximisation. Blome et al (2007)
1
note
that the use oI ALM and LDI strategies has resulted in two main developments:
A move towards greater duration oI Iixed income portIolios and greater use oI
derivative instruments to hedge interest rate risk;
Greater investment in so called alternative instruments, such as private equity, real
estate, and hedge Iunds in search oI the elusive alpha`.
A range oI actuarial and Iinancial assumptions including mortality, inIlation, interest rate risk
and the equity risk premium are Ied into the portIolio management system in order to generate
scenarios that match assets with liabilities. Various asset allocation mixes and time horizons are
Iactored into the equation along with scenarios with regards the Iunding position and
contribution levels oI the pension Iund. The objective is to engineer the optimisation oI the
Iund by Iocusing on a single state variable, i.e. the value oI the 'liability portIolio. The
emphasis on matching assets and liabilities as the starting point, Iorces the pension Iund
manager to Iocus on key assumptions and their quantitative implications. By developing ALM
as a strategic benchmark, as opposed to market indices or industry peer groups, investments will
be geared to meeting Iuture obligations to retirees.
Liability driven strategies at a basic level involves the restructuring oI the balance oI the
pension portIolio to an over-weighted bond position in order that assets match the duration oI
liabilities. As covered in chapter 3, the insurance industry has practised asset and liability
matching through the use oI a replicating portIolio wherein pension annuities that Iall due in
1
165
year X are matched by a cash-Ilow in year X generated Irom instruments such as government
bonds that provide a secure income stream. This structural Iorm however can have
disadvantages in terms oI transaction costs, the sacriIice oI potential equity gain and the
availability oI a suitable liquid bond market.
Modern ALM studies rely on stochastic models that generate thousands oI scenarios with
diIIerent probabilities attached to each. ALM systems are now used as integrated planning
programs to simultaneously determine investment, Iunding and where applicable, indexation
policies (Blome et al 2007)
1
.
A key aspect oI pension Iund management is the relationship between meeting liabilities and
long term interest rates. A small percentage change in long term rates can have devastating
repercussions Ior the Iund iI inIlation and interest risk is not hedged. PortIolio diversiIication is
only part oI the equation when it comes to employing sound risk management strategy.
DiversiIication helps to control asset volatility but does little to reduce risk on the liability side.
However, just as asset allocation strategies are oIten actively managed, so too should liability-
hedging in order to take advantage oI the economic cycles in inIlation and interest rates.
A typical pension Iund would have liabilities with a duration oI between 10-17 years. In asset
driven pension portIolios, the Iixed income portion normally ranges Irom 30 percent to 60
percent oI the total asset values and consists oI short duration bonds. As interest rates are
reduced, pension Iunds experience a shortIall in meeting their liabilities due to the eIIect oI
duration on bond maturities; this leads to a Iunding gap. The restructuring oI the portIolio to
that oI LDI will help hedge the interest rate risks which cause liability value changes. For a DB
pension Iund, the LDI process oI using swaps to match anticipated Iuture cash Ilow needs
simpliIies the objective to a return achieving or exceeding LIBOR.
For pension schemes that have Iunds 10 15 times greater than the balance sheet oI the
sponsor, there is a strong case Ior hedging Irom 75 100 oI liabilities. However, the cost oI
hedging can be expensive leaving many schemes unable to aIIord to take mark-to-market` risk
against liabilities. In addition, the costs oI portIolio insurance in hedging strategies are also
compounded by opportunity cost. There is thus a need Ior a systematic balancing act in order to
close any Iunding gap.
Unhedged asset positions may experience a good run or beneIit Irom a rising discount rate, thus
enabling a manager to hedge a portion oI the Iunds liabilities and lock in the newly-improved
Iunding ratio. The objective is to be adopt a dynamic de-risking strategy wherein the manager
is constantly moving the downside risk level up, without giving away the upside potential that
is required to get back to Iull-Iunding. This type oI tactical interest rate strategy involves the
manager taking a view on market rates and having a hedging plan which is triggered when they
reach the target level.
The collapse oI the stock market has exposed the risks oI concentrating on conventional asset-
driven strategic asset allocations, and led to increased discussion by Pension Funds and LiIe
Insurance Companies about the merits oI shiIting to liability driven strategies. In the UK, LDI
strategies appear to be given greater signiIicance in the corporate sector where they play an
1
166
important role on the balance sheet, as opposed to public sector pension schemes where the
Iocus remains much more on asset management than on management oI liabilities.
The key issue Ior LDI strategies is the management oI cash Ilows. Alongside bonds, managers
may consider hybrid pension Iund structures which include growth assets matched with
inIlation-linked cash Ilows. However, the most eIIective approach in this current economic
climate is Ior managers to vary the hedge tactically in response to changing correlations
between liabilities and assets. The implementation oI portIolio risk-immunization lies at the
heart oI LDI strategies; with the pressure on underIunded DB schemes mounting, the emphasis
is thus moving towards liabilities in terms oI determining the optimal investment model.
1. Criticism of the ALM approach
Like all other attempts to meet pension obligations, the ALM strategy has its critics. Inderst
(2008)
1
outlines a number oI obstacles to the ALM approach:
Uncertainty projecting cash-Ilows is oIten diIIicult as a result oI constant changes in
the economic and regulatory environment;
Assets pension liabilities are spread over the long term, thus posing problems in
Iinding suitable vehicles to match assets with obligations over a 20- 30 year period;
Index-linking pension payments are oIten linked to inIlation or salaries. However, the
range and size oI inIlation-indexed instruments on the markets is limited;
Pension cost a more conservative investment approach to asset management will result
in the need Ior either higher contribution rates by sponsors and/or members, or lower
pension beneIits in the Iorm oI reduced indexation.
The application oI ALM is prominent in the Netherland and Germany with pension Iunds
required to regularly perIorm ALM studies. UK pension schemes however express reservations
about ALM, as it does not take into account the sponsor`s covenant, on which the pension
promise in the UK is based.
Inderst draws attention to a number oI issues concerning the application oI ALM strategies in
practice:
Change ALM is valid only under quite restrictive conditions that are seldom met in
practice e.g. risk Iactors and correlations between asset classes are not constant over
time;
Sensitivity a small change in the assumptions can lead to a very diIIerent Iinal asset
allocation e.g. building a contribution holiday into the assumptions in order to deliver a
preIerred result;
Behavioural risk preIerences oI Iiduciaries and sponsors change signiIicantly over the
cycle in line with any change in the Iunding position;
Liabilities as markets Iluctuate, the Iunding ratio becomes volatile and may lead to
liquidity problems in meeting liabilities as they mature.
As a consequence oI adapting a liability-driven approach to portIolio optimisation, pension
1
167
Iund managers increasingly steer towards the use oI bonds. The emphasis is currently on the
use oI long-duration bonds, liability hedges and asset diversiIication while lowering exposure
to equities. The recent crash in asset values has also saw pension Iunds allocate cash to
portable alpha` strategies that are in eIIect bolt-on liability-based portIolios. Such strategies
involve the use oI derivative instruments to protect against stock-market volatility and hedge
against currency Iluctuations.
However, it is important not to rush into a liability-driven strategy without considering all the
repercussions Ior doing so. II the current levels oI corporate bond yields are considered
alongside the growing deIicits oI DB schemes, it is likely that the adoption oI an ALM
strategy would lengthen the pension Iunds` recovery times signiIicantly. Henderson (2009)
1
quotes John-Paul Augeri, a principal at Towers Perrin: 'pension Iunds will need to reconsider
their asset allocation and risk strategies, as the level oI government bonds expected to enter
the UK Iixed income market over the next Iew years is likely to aIIect long-dated debt and
pension Iund valuations. Steeper, long-term interest rate curves and higher interest rates will
radically alter the structure oI pension schemes in that although long-term liabilities will be
reduced, the increase in the number oI bonds being issued may damage the returns oI Iunds.
2. ALM and fiduciary management
A signiIicant development in the pensions industry has been the desire by Iiduciaries to
exercise more control over the impact pension Iunds can have on company Iinances. New
accounting standards and pension rules have Iorced Iund managers to value pension
surpluses/deIicits on their balance sheets at market prices thus increasing their transparency.
Marking to market however has it`s downside as currently witnessed with the present recession.
The resulting devaluation oI pension Iund assets has led to a crisis in the Iunding ratio oI most
pension Iunds. The impact oI the new standards, coupled with a desire Ior more predictable
returns, has thus prompted companies to pursue ALM strategies.
The complexity involved in the application oI ALM and LDI modeling makes it much more
diIIicult Ior Iund trustees or directors to understand or interpret the risk management strategy
and therein provide the necessary level oI governance. There is thus a need Ior improvement in
the training oI personnel in such sophisticated techniques.
1
Henderson, J. (Ed.). (2009, April 30). Economic crisis could lengthen deficit recoveries. Retrieved Irom
http://www.ipe.com//crisiscouldlengthendeIicitrecoveries31598.php
168
Chapter 18 A vehicle for the provision of sustainable income
The role of annuities
With individuals now expected to live an additional 20 to 30 years aIter retiring Irom work, the
gauntlet has been thrown down in terms oI the creation oI a suitable Iramework Ior the
provision oI sustainable income. In many European countries individuals are required to have
their accumulated pension assets converted to an annuity at the time oI retirement. Annuities
are structured in the Iorm oI guaranteed monthly payments made by insurance companies to
pension scheme members upon retirement.
Increased liIe expectancy has led to a growing demand Ior products which oIIer more Ilexible
annuity and drawdown arrangements. Legorano (2009)
1
reports on a proposal Irom the
European Fund and Asset Management Association (EFAMA) that 'the best investment
strategy in retirement is to hold a signiIicant proportion oI pension assets in equity early on in
retirement and to switch progressively to bond holdings and annuities over time. It is likely
that individuals would Iare better iI they were not limited to the type oI investment product they
can chose in structuring their retirement. By having a diversiIied equity portIolio it is possible
to make better use oI capital through the generation oI higher retirement income at a
comparatively low risk. EFAMA suggest that 'the regulatory Iramework in Europe should
seek a reasonable balance between satisIying the concerns oI policymakers and addressing the
needs oI retirees. A more balanced regulatory Iramework Ior the payout phase oI Iunded
pension schemes would spark innovation in the European Iinancial market and stimulate the
creation oI payout products tailored to meet individuals` retirement needs. They add that
Member States which insist on the purchase oI annuities upon retirement should ' allow the
upper age limit Ior compulsory annuitization to be increased toward 85 in order to achieve a
proper balance between the objectives oI securing a suIIicient level oI retirement income and
protecting retirees Irom longevity risk as they reach advanced ages.
However, with the Iall in interest rates to near zero across Europe and the prospect oI inIlation
reappearing, annuities now look like an expensive guarantee Ior the insurance company. The
situation is exacerbated with the increase in risk oI credit deIault Ior non-proIit bonds that
secure the annuities oI the portIolio. As a result, provision has had to be made in the capital
reserves oI many pension schemes to absorb any such risk.
In addition, there appears to be a shortage oI products suitable Ior cross border schemes; this is
coupled with a lack oI awareness on behalI oI trustees and sponsors as to the range oI product
options available to them. Legorano proposes that 'one oI the problems with traditional
retirement Irameworks is that they do not consider the scheme portIolio`s ability to generate
sustainable income levels. Focus is quite oIten concentrated on the risk-return trade-oII with
regards portIolio management and not the more pressing issue oI longevity.
There are a range oI outcome-based solutions that can be considered over and above annuities,
such as the use oI principal protected products and structured notes. Legorano claims that non-
1
Legorano, G. (Ed.). (2009, February 18). EFAMA research backs income drawdown strategies . Retrieved Irom http://globalpensions.com/
169
traditional approaches could provide a new retirement income eIIicient Irontier`, which would
be more eIIective Ior tradeoIIs on retirement income.
Effect of UK economic policy on annuity rates
In the UK the recent government policy oI injecting cash into the economy in the Iorm oI
quantitative easing has caused the pensions industry a headache. In the Iirst halI oI 2009 as the
deIicit widened, the government was Iorced to buy back 150bn oI gilts and bonds in order to
Ilush money into the economy and kick-start activity. However, this process oI stimulating
demand Ior gilts through quantitative easing has had the undesirable eIIect oI driving up short
term bond and gilt prices and subsequently cutting bond yields which has lead to the increase in
the liabilities oI pension Iunds.
In addition, the long-term value oI bonds are also eroded by high inIlation; thus as the price oI
bonds Iall, their yield i.e. the interest rate the government must pay to borrow, goes up. In
attempting to stimulate the economy the UK government inadvertently Iorced down both long
term and short term interest rates creating a situation where the mark to market` valuation oI
pension Iund liabilities is much greater.
Falling corporate bond yields and the expected increase in inIlation have thus had a knock on
eIIect Ior annuity rates. The yield on gilts is thus a key Iactor when company pension schemes
calculate their obligations to Iuture pensioners. ne solution Ior this problem would be Ior the
UK government to issue government bonds that match the liIespan oI workers and pay interest
over 40 to 50 years. Such long term issuances would have the eIIect oI breathing conIidence
into the market, increasing yields and therein decreasing pension liabilities.
170
Part V
Chapter 19 Maintaining standards in the pension sector
Who is guarding the guardians?
Standards are literally everywhere and cover every aspect oI working liIe, helping society to
evolve and change shape. Standards and requirements diIIer in the various parts oI the world; in
the European Iinancial services sector however, the trend over time has been towards
harmonization.
Governance oIten lurks in the background oI EU policy and can appear too regimental and
extremely boring by nature. Sometimes it may seem that it is only when standards Iail that
organization`s truly become aware oI their existence. It is not possible to deIy the laws oI
economic gravity and do away with the cycles oI boom and bust; to do so is to tempt Iate. It is
important however that good governance is incorporated into the pension industry culture and
therein becomes an integral part oI how companies do business.
As standards proliIerate throughout the pension industry, they have a tendency to reIlect the
needs oI business. The Iinancial services industry in Europe has consistently argued Ior selI-
regulation in order to maintain business continuity and be in control oI risk management
processes. The Iear Ior Iree-marketers is that too much regulation impinges on the industry`s
quest Ior innovation and therein stiIles growth. By the industry adopting such a selI-regulatory
position, standards run the risk oI evolving into a Iree market response to regulation. The
collapse in the value oI DB pension schemes over the last Iew years has demonstrated the
consequences oI having a relaxed selI-regulatory environment. The argument against selI-
regulation is thereIore that standards can be compromised by commercial interest.
1. Fiduciary management
With the trend towards the establishment oI DC schemes as an alternative to DB plans
continuing, there will be a greater demand Ior regulatory and governance practices in order to
oversee the new risk-sharing structure between sponsor and members. Fiduciary management
is paying a prominent role in terms oI Iund governance. As scheme sponsors increasingly seek
to outsource portIolio and risk management activities, a premium has been put on the
knowledge and understanding oI pension systems.
Watson & Wyatt note the Iollowing Iactors that will have an impact on the pensions industry in
the coming years:
A renewed emphasis on governance` and use oI Iiduciary management;
171
Focus on risk-modelling as a result oI the Iinancial crisis;
New regulation on issues oI solvency which will rein in the Iinancial industry.
The conditions Ior pension Iunds move in line with the economic climate and the evolution oI
regulatory regimes. As the operating environment becomes more complex, sponsors look
towards the Iiduciary model Ior external advice on plan design, risk management strategies and
the use oI alternatives as an asset class. It is the Iiduciary responsibility oI Iund managers to
ensure that pension obligations are met; however this does not mean that managers should be
able to invest and Iree to use whatever instruments available in order to maximize portIolio
returns. By understanding the impact oI change, sponsors will be more inIormed when
designing dynamic structures that can adapt to the shiIting circumstances; as such, a more
sophisticated perIormance measurement Iramework will evolve which better accounts Ior risk.
Henderson (2009)
1
reports on the emergence oI a post-product` era with the creation oI
bespoke, unbundled services Ior pension Iunds. With Iiduciary management rising to the Iore,
the emphasis will be on the delivery oI solution-Iocused partnerships between pension Iunds,
asset managers and consultants. In the past consultants acted as gatekeepers to pension Iunds;
this inevitably encouraged a product-pushing mentality by advisers and suppliers. That
situation is now set to change as greater Iocus is put on a new client/provider dynamic with
service providers required to listen to their clients` needs and expected to be accountable Ior
any advice given.
2. Need for good governance
Both the current recession and Iinancial breakdown appear to be a consequence oI each other.
A synchronized drop in the Iunding levels oI pension schemes has leIt many European
countries with a potentially unstable retirement apparatus, hence the need to have a well-
designed process Ior investment decision-making and risk control. The impact oI the crisis on
Iinancial markets and pension Iund valuations has led to the emergence oI governance` as a
prerequisite Ior sound asset allocation decision making. It is the role oI pension Iund Iiduciaries
to design a Iramework to ensure that investment objectives are clear, the risk proIile oI
beneIiciaries understood, and that the required level oI expertise is on board in order to deliver
adequate risk management. This Iramework should be backed up by a clear mission statement
and mandate Irom the sponsor and trustees
The most important inIluence on whether a pension scheme can meet its obligations is neither
regulation, nor the Iunding standard, but moreover the prudent management oI that scheme by
its trustees coupled with the ongoing support oI the sponsoring employer. In order to achieve
this objective, trustees need to consider the long term sustainability oI the Iund by Iocusing on
strategies that examine constraints and are realistic about costs and investment risks.
Trustees oI pension Iunds are now adopting a more hands on` approach to governance and
setting speciIic target returns. The relationship between stakeholders which include advisers,
the manager, the sponsor, and trustees, is becoming a much more collaborative one in terms oI
strategic asset management. In some cases however, schemes are adopting an extra
1
Henderson, J. (Ed.). (2009, November 26). Fiduciarv management to evolve as risk will be the new return. Retrieved Irom
http://www.ipe.com//management-to-evolve-as-risk-will-be-the-new-return33354.php
172
precautionary measure by having the governance oI the Iund and pension trustees separated.
To this end trustees act as a non executive body overseeing the Iund manager and associated
activities.
As sponsors review their mandates Ior the coming years, asset allocation will need to be
aligned with objectives to manage risk or to enhance return. Good governance involves risks
being split into those that are related to long-term strategic risk, and those that are short-term
tactical risks. The assets oI the portIolio may be comprised at any one time by a mixture oI
equities, bonds, cash or alternatives; it is the continuous eIIicient management oI this mix oI
assets which enables sponsors to honour the scheme commitments to members.
3. Committing to responsible ownership
Stewart (2009)
1
highlights that 'recent events have shown how the Iailure to hold corporate
leaders to account Ior their decisions on risk management can have a catastrophic eIIect on the
Iinancial system, the economy, the corporations themselves and ultimately on the well-being oI
members oI pension schemes. Committing to responsible ownership will help ensure that
investment decisions work in the long term and lead to a more sustainable Iinancial system.
Building an understanding oI risk into investment decision making and engagement with Iirms
are essential responsibilities oI pension Iunds.
Stewart reIers to a joint statement issued by John McFall MP, chair oI the UK Treasury Select
Committee and Terry Rooney MP, chair oI the Pensions Select Committee in January 2009,
which claimed that pension trustee boards "need to develop clear policies and guidance
mandating their Iund managers to engage in dialogue with companies, to vote at company
AGMs and to report back on what impact their engagement has had. The objective was to
encourage major investors to take a more active role in corporate governance by asking
diIIicult questions oI the companies they invest in.
The joint statement outlined three next steps Ior pension Iunds:
Schemes should insert a 'do not harm' clause into their statement oI investment
principles (SIP) requiring Iund manages and other advisers to demonstrate
investment decisions are not causing 'systemic harm' to the stability oI the
Iinancial system;
Institutional investors, particularly large pension Iunds, should sign up to the
United Nations Principles oI Responsible Investment (UN PRI) as soon as
possible;
A collective reporting and monitoring body should be established possibly as
part oI the Investment Governance Group (IGG) set up under the recent
Myners Review to ensure pension Iunds are adopting the 'do not harm'
clause.
Rooney pointed out that people saving Ior retirement "want to know that their pension
Iunds are being invested responsibly, and Ior the long-term." The statement added: "We
thereIore believe that there is a need Ior any legal obligations to be more clearly embedded
1
Stewart, N. (Ed.). (2009, January 19). Pensions must be more responsible or face legislation. Retrieved Irom
http://www.ipe.com//mustbemoreresponsibleorIacelegislation30273.php
173
in the principles and practice that inIorm investment decisions and to include issues oI
systemic risk".
Over the last two years the pension Iund industry has been aIIected by the Iallout Irom Iinancial
mismanagement and the volatility in the Iinancial system. However, as in the Iable oI the boy
who cried wolI` there is no point in saying I told you so`! It is time now to put the mechanisms
in place that will ensure pension Iunds will be Iully Iunded and therein deliver on their
commitments to the Iuture. The aim oI regulation is to underline the need Ior good risk
management; its` purpose is not to undermine the activities oI Iund managers. Regulation
should oI course be contested every step oI the way by the Iund management industry, however
it is evident at the same time that the industry can not blindly continue to assert its right to do
things its own way.
The best government strategy Ior dealing with uncertainty is to put in place regulation which
Iorces pension Iunds to protect themselves against market downturns. It is thereIore the role oI
the legislators to watch over regulatory regimes in order to saIeguard the Iuture Ior pension
scheme members. With this in mind, government policy should set the standards Ior regulatory
authorities to Iollow. Such standards need to be developed and prioritized in accordance with
the investment environment. To this end the task is to have risk-based regulation at every stage
oI the pension liIecycle with a light touch` where risk is low, and a heavy touch` where risks
are high.
Recent events would suggest that boom and bust are in Iact two sides oI the same coin; in order
to prevent the bust legislators should do all they can to discourage a boom situation. It thereIore
is necessary to increase regulation to prevent the Iinancial crisis Irom reoccurring. Regulation is
not just about the introduction oI speciIic measures to improve existing pensions systems, but
also about a change in culture. Regulation is only one oI the three R`s needed to change the
pension system; responsibility and relationships with beneIiciaries are just as important. Those
companies that practise old style relationship pension provision appear to have weathered the
recent Iinancial storm the best.
It is the duty oI trustees to consider the pension Iund role in society in terms oI where the asset
allocation should be. The asset allocation is usually covered in the sponsors` covenant which is
reviewed every 3 to 5 years. Most companies will have annual checks oI their pension Iunding
levels to ensure that there is no deIicit. It is also Ior the trustees to monitor and control the
exuberance oI Iund managers so as to avoid excessive risk taking and over dependence on
mathematical models. One oI the primary roles oI corporate governance is to outline the
guiding principals Ior Iund management; additionally trustees should insist on the stress testing
oI pension Iunds in order to Iacilitate access to important inIormation. A more holistic
approach would also have pension Iund trustees Iocus on ALM strategies as opposed to short
term gain.
One oI the problems with regards the Iailure oI modern Iinance is the lack oI understanding by
the industry oI how the models actually work. The situation is oIten compounded by a
groupthink` approach in the Iinancial sector which puts pressure on getting business completed
at whatever cost. At times during 2009 it seemed as iI the long-term pension models no longer
Iunctioned; thankIully a recovery in the stock-markets has leIt sponsors in a more positive
Irame oI mind. However there are still many lessons to be learned and a need Ior greater
governance in order to prevent pension Iunds being structured as a giant bet on the stock
market.
174
Summary of research findings on safeguards used by pension fund trustees to minimize
risk
The importance oI the role oI trustees was emphasized in the survey response to the question oI
what saIeguards are used by the pension scheme to minimize risk (see Diagram below). OI
those surveyed 23 considered holding regular trustee meetings at top oI the agenda with a
Iurther 22 putting an emphasis on trustee training. The monitoring oI investment perIormance
by trustees was also high in the list oI priorities at 23 with the regular review oI scheme
advisors at 19. In addition, the review oI the employer covenant was deemed as important by
14 oI respondents.
Diagram 1: Methods used to controI risk
Safeguards used by pension fund trustees to minimize risk
a. Hold regular trustee
meetings
23 22.77
c. Monitor performance of
investments
23 22.77
e. Trustee training 22 21.78
d. Regular review of scheme
advisors
19 18.81
b. Regular employer covenant
review
14 13.86
Total: 101
175
Chapter 20 Through the looking glass - Issues of concern for 2010
'When the Winds of Change are Blowing most build shelters to protect themselves.
Some build windmills and take advantage of the change..`
1. Solvency Issues
The signiIicant deterioration in solvency positions as a result oI the Iinancial climate is raising
the possibility oI plan deIaults and thus creating pressure Ior revised investment strategies.
Throughout 2009 the industry witnessed corrective measures in the Iorm oI contribution
holidays and reduced pensions.
There are enormous challenges ahead Ior the pensions industry, given the ever changing market
environment. In a complex investment world only the Iittest survive; not all institutions are
Ilexible enough to eek out opportunities. Moreover, it is not necessarily the Iittest in terms oI
the strongest that will survive in the Iuture, but moreover the Iittest in terms oI their
adaptability.
The commitment oI sponsors to DB schemes has leIt many organizations exposed in terms oI
their solvency position. Companies that have DB schemes with guaranteed returns have
experienced serious diIIiculties due to the reduction in Iixed income and equity returns. As a
result, the developing trend on behalI oI plan sponsors to move towards DC structures is likely
to accelerate.
2. Risk Management Strategy
The Iinancial situation has been akin to a perIect storm` Ior the Iund management business
over the last couple oI years in terms oI Ialling stock values and bad credit markets. The crisis
has unveiled the vulnerability oI systems to the occurrence oI extreme events, and risk
exposure in relation to credit and liquidity. The importance oI diversiIication in reducing risk is
leading to a greater Iocus on hedging strategies in order to address the volatility oI the markets.
Risk management processes are now in the spotlight with particular emphasis being given to
the use oI stress-testing`. In such instances, the guiding hand oI the chieI risk oIIicer`
becomes ever more crucial to proceedings.
3. Benefits and stakeholders
The pension landscape appears to be in a constant state oI transition. It is important to
remember that Iund managers, the economy, retirees, workers, companies, the environment,
and productivity are all interrelated parts oI the same system. It is unIortunately the retirees
who seem have paid the heaviest price as their pension Iunds have been decimated with the
bursting oI the asset bubble. There is a need thereIore Ior all players to keep their Iocus on the
core issue oI creating an environment that allows employees to turn today`s savings into
tomorrow`s retirement income.
4. Agency issues
The inter-relationship between the role oI the intermediaries, the pension Iund and the
individual are highlighted in the diagrams oI the pension Iood chain` and the interconnected
Iood chain` below.
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Diagram 19.1: The pension fund food chain
Source: Watson Wyatt 2009
Diagram 19.1 draws attention to the various constituents oI a pension Iund in terms oI the role
they play in the pension Iund Iood chain. The concept is expanded to a wider dimension in
Diagram 19.2 which highlights the interdependency oI the world economy and growth with the
creation oI sustainable purchasing power Ior the masses through the development oI pension
systems.
Diagram 19.2: The interconnected 'food chain'
Watson Wyatt (2009)
1
noted that 'pension Iunds with very Iew exceptions are not resourced to
to manage all their activities in-house. As a result, they employ agents` in both advice roles
such as investment consulting, and delegated roles such as investment managers. This exposes
them to the agency problem` in that agents` interests may not coincide with those oI the Iund.
The goals oI pension Iunds and their agents may oIten be in conIlict given that the Iormer is
preoccupied with meeting its pension commitments, whereas the latter is oIten more driven by
the generation oI Iees. Consequently, the pension Iund may suIIer Irom a lack oI cohesion and
increased costs.
1
Watson Wyatt (Ed.). (2009). Managing the Pension Fund Food Chain. Retrieved Irom http://www.watsonwyatt.com///.asp?ID16472
177
A signiIicant problem that has emerged over recent decades is that oI ownership` oI pension
Iunds. The traditional pension scheme was established with the members as the true owners oI
the Iund, with investment managers acting as servants, and trustees as intermediaries. The
balance oI ownership has however shiIted dramatically in recent years Irom individuals to
institutions to the extent that it can interIere with the ability oI the trustees to use their inIluence
and control over agents. Watson Wyatt (2009)
1
observe that iI pension Iund liabilities and
assets are considered as an extension oI the company`s balance sheet, then the shareholders oI
the sponsoring company should be seen as the ultimate owners. However, many oI these
shareholders are themselves pension Iunds. The problem therein is that iI it is unclear who the
owners actually are, then it becomes more diIIicult to maximise the return on the Iund assets.
A variety oI agents appear to be increasingly exploiting this uncertainty and oIIer a myriad oI
services to Iund sponsors; whether all oI these services are actually adding value is an issue oI
growing debate.
5. Value proposition
The pension industry has suIIered Irom the perennial problem oI transparency, with hidden
administration and management charges being built into the structure oI many products. A key
issue in determining the merits oI using intermediaries is to consider iI Iees charged are
matched by value added to the interests oI clients. Quite oIten when all the various layers oI
Iees are totalled, it becomes apparent just how diIIicult the task is to outperIorm both the risk
Iree rate plus the inherent charges without taking additional risk.
A new trend is emerging Irom the remnants oI the Iinancial crisis as the investment industry
moves away Irom commission-driven product sales to that oI Iee-based advice. In the past the
emphasis has been on a product-push` strategy in terms oI initial commissions paid to the Iund
manager Ior investing capital. This change oI direction is being bolstered by support Irom the
regulators who want the industry to replace the levy oI initial Iees with standard Iees Ior
managing the portIolio.
There has been signiIicant controversy over the level oI perIormance Iees in recent years, with
many Iund managers charging Iees oI up to 25 oI any proIits generated. These remuneration
scales can encourage mangers to seek greater returns, and in the process oI doing so expose
clients to unwarranted risk. The Iund manager may be tempted to act as a gambler with
attractive incentives Ior any bets that pay oII; and yet more oIten than not, there appears to be
no downside or punishment should the manger lose the bet.
Many pension Iunds Ieel disenchanted with the level oI Iees relating to hedge Iunds in
particular in terms oI value Ior money`. Investors are willing to pay Iees to managers that
demonstrate skills over the long term, but are becoming more reluctant to pay active
management Iees Ior those managers relying on beta or even luck`. At some point during
proceedings, investors ask the question as to whether the Iees charged justiIy the returns; this is
particularly so in the case oI Iund oI hedge Iunds` where there oIten appear to be additional
layers oI charges with little or no added value apparent.
1
178
The traditional Iee model is oIten seen as over-compensating asset managers in rising markets;
however it bears no relation to the value added by the manager when reaching the long-term
investment objectives oI the client. PerIormance-based compensation mechanisms can
encourage risk-taking and short-term opportunism and may not reIlect the true nature oI
pension Iunds which have by deIinition a longer duration. As asset owners become
disillusioned with uncapped perIormance Iees there has been a call Ior a whole-scale
transIormation oI the relationship between asset manager and asset owner to a value-oriented
long-term partnership in a bid to align the long-term interests oI the two parties. It is becoming
increasingly common Ior trustees to negotiate a hurdle rate` or minimum return beIore
perIormance Iees are paid out and also to select longer term mandates that relate more
speciIically to the Iund`s liabilities. A more equitable proposition would thus be Ior the bonus
structure to spread perIormance-related payments to Iund managers over two or three years,
and claw them back iI annual results are negative. An alternative solution would be to combine
a Iixed Iee covering set-up and running costs, in parallel with a perIormance-based Iee relating
to the investor`s long-term investment objectives.
There are also concerns with regards the justiIication oI certain activities incorporated in the
agents` services. Retainer-based pricing can be diIIicult to operate eIIectively; in addition,
consultants who promote 3
rd
party Iunds open themselves to compromise in their role as
independent advisors. This view was echoed by Watson Wyatt (2009)
1
when they announced
that 'within the last two decades, investment management has evolved Irom a proIession into a
business; a business that is engaged in manuIacturing relative returns. That may involve some
miss-alignment because pensions are ultimately paid with absolute returns and in aggregate; as
such there can be no positive relative return, only the market return less Iees and costs.
Ultimately the Iree market` should act as a controlling mechanism Ior overpricing, however as
the pension Iund industry is very much a concentrated arena, the market tends to have limited
control.
There is oI course increasing pressure Ior intermediaries to perIorm in order to meet
benchmarks. The stressed market conditions coupled with solvency issues have led to managers
applying numerous investment styles to meet targets. Investment strategies have no guarantee
that they will work; it is the duty thereIore Ior each scheme sponsor to outline clearly in their
mandate the parameters oI risk and return that meet their objectives and also the remuneration
scales that they would deem equitable Ior agents to be paid.
In order to manage intermediaries more eIIectively, Watson Wyatt proposed that pension Iunds
apply game theory, which is the Iormal study oI conIlict and cooperation between
interdependent agents. The key issues to address are as Iollows:
Alignment oI incentives;
Disclosure oI all relevant inIormation;
Monitoring based on meaningIul measures oI success`;
Responsible agents having appropriate accountabilities.
1
179
This list provides guidance on the key steps pension Iunds need to take to improve their
eIIectiveness.
Five key issues that need to be addressed are:
a) Am I measuring my agents well, and is my measurement period optimal?
Measurement is an essential part oI good management; it is important however to have
the correct balance between short-term measurement and long-term goals.
b) What should be done about consultants?
Pension Iunds need to be sure that they are getting value Ior money Irom their
consultants and that their interests are aligned correctly. To achieve this measure
Watson Wyatt proposed that Iunds advocate a balanced score-card approach to the
monitoring oI advisors.
c) What should be done about managers?
A two level Iee structure is proposed in order to help improve alignment oI interests as
Iollows:
A Iixed Iee in Iixed currency which is to cover the overhead costs oI the
business;
A variable Iee related to perIormance achieved rewarding the manager Ior their
skill and contributing to bonuses and shareholders` proIit margin.
In addition there is need Ior the use oI longer term mandates that relate more
speciIically to a Iund`s liabilities, and consider absolute return investing.
d) What part does manager turnover play in successIul governance?
It is important that managers who miss benchmarks and underperIorm are replaced. To
this end there is a need Ior pension consultants to design systems that measure the skill-
set oI managers in terms oI both hard and soIt Iactors. When identiIied, any weaknesses
should be brought to the attention oI the managers at an early stage with a view to
making the necessary adjustments to meet perIormance targets.
e) What should be done about brokers?
Many pension scheme providers rely on expensive brokers to sell their products. High
broker commission levels make it more diIIicult to achieve economic returns over the
invested period. It is the role oI the advisor thereIore to ensure that brokerage expenses
are transparent and help negotiate commission levels on behalI oI clients.
Summary of research findings on the perceived transparency of fees
Contrary to the view oI many industry critics oI Iee structures, those who are most directly
involved in the negotiation and setting oI external Iund managers` Iees i.e. the pension scheme
directors, trustees and administrators themselves, appeared to be comIortable with the level oI
transparency oI Iees levied by Iund managers. Over 43 however either agreed or strongly
agreed that Iees were not transparent enough (see Diagram below).
180
Diagram 19.3: The transparency of externaI fund manager fees
Are fees charged by external fund managers transparent?
d. Disagree 12 52.17
b. Agree 8 34.78
a. Strongly agree 2 8.70
c. No opinion 1 4.35
e. Strongly disagree 0 0.00
Total: 23
Although the majority oI those surveyed agreed that they were happy with the transparency
level oI Iees charged by external managers, this does not mean that reward scales were not
being closely scrutinized by administrators.
Summary of research findings on benchmarks used in the selection process of an external
fund manager
As an extension to the question oI Iees, the survey also researched the attitude oI pension
scheme management in terms oI benchmarks used in the selection process oI external Iund
managers. 20 oI respondents declared that Iees where indeed an integral part oI the selection
criteria with a Iurther 18 highlighting both the investment and risk management process as
being key Iactors, Iollowed by the actual perIormance oI the manager at 17 (see Diagram
below). The level oI reporting also played an important role with 16 oI respondents claiming
that they used this as a metric. Finally, 13 oI those questioned considered the size oI the
organization supporting the Iund manager to be a signiIicant benchmark Ior use in the process.
Diagram 19.4: Fund manager seIection benchmarks
Benchmarks used in the selection process of an external fund manager
d. Level of fees 21 19.44
b. Investment process 19 17.59
c. Risk Management process 19 17.59
a. Performance 18 16.67
e. Level of reporting 17 15.74
f. The size of the organization 14 12.96
g. We don't use external fund
managers
0 0.00
Total: 108
181
Chapter 21 Defining the pension industry of the future
A} The pens|on fund journey
Pension Iund management is a journey rather than a destination; it is thus oI great importance
that there are checks and balances along the way in order to ensure that objectives and targets
are being achieved. To this end, it is the task oI governance to reconcile short term tactics with
the long term strategy; there is however no secret Iormula Ior success. Watson Wyatt (2009)
1
identiIied six major trends that they believed would have a growing inIluence on pension Iund
development in the near term:
1. Improvements in governance
The role oI governance will become increasingly important as attention Iocuses on risk
management Iunctions. Organizations will need to be more active in order to have an impact on
Iund managers. It is likely that changes will be Iorced through in organizational design with the
ChieI Investment OIIicer, Iiduciary management and non-executive boards becoming major
centres oI inIluence.
As the pension industry becomes more complex, there is a need to be able to adapt in order to
secure any competitive advantage. Watson Wyatt observe that 'by trying to engage with Iund
managers and outlining issues with which they may or may not agree, sponsors can avoid the
upheaval oI having to divest and shiIt their assets to other Iund management groups.
2. Product proliferation
Product specialisation will invariably lead to proliIeration, wherein new versions and
extensions oI pension products evolve. With a greater emphasis being put on liabilities, pension
Iunds will look more to alternative assets and products structured to deliver absolute return`
with a view to securing an advantage in the marketplace.
As the deIinition oI variables such as risk, style and scope oI mandates begin to broaden there
is an increasing requirement Ior transparency. In essence however, modern Iinance oIten
appears to be both complex and opaque. The pace oI innovation has been so great in the last
two decades that it has surpassed the comprehension levels oI many pension Iund managers and
regulators alike. One oI the problems with innovative products is that although they contribute
to so called Ireer markets`, they may also, by nature oI their complexity, Ioster a non-
transparent environment wherein it is diIIicult to put a credible value to assets in terms oI mark
to market` values. The objective is not to stiIle innovation in terms oI product development,
but moreover to ensure that any over-exuberance by Iinancial institutions in their application oI
innovative products does not bring the pension system crashing down.
1
Watson Wyatt (Ed.). (2009). Defining the pension and investment Industrv of the future. Retrieved Irom
http://www.watsonwyatt.com/////2.pdI
182
3. Pension design, towards a DC model
With the shiIt in social structures away Irom the traditional paternalistic approach oI pension
provision, employer DB schemes are gradually being phased out and replaced by DC schemes.
This trend is largely being driven by demographics, and the regulatory environment; as such it
is opening a new Irontier in corporate governance with sponsors being expected to develop
liIestyle strategies Ior plan participants. The transition between the DB and DC pension models
provides administrators with a great opportunity Ior enhancing the value proposition to
members. This can be achieved through improved investment eIIiciency in terms oI cost
structures, and asset allocation strategies that include the selection oI alternatives.
As sponsors move away Irom the costly guarantees oI DB schemes, there will be a need Ior the
development oI more sophisticated risk protection strategies. Schemes with DC structures are
re-examining their design in order to limit risks Ior those people who are close to retirement.
Through the aid oI technology and development oI suitable deIault options, managers will seek
to design liIe-cycle savings models that deliver optimal investment strategies which provide an
adequate income level Ior retirees.
4. Organisational change - new managers, new intermediaries, new competencies
With the Iinancial crisis set to continue over the Ioreseeable Iuture, the key to recovery will
depend very much on how the players react and adapt to environmental Iorces. A number oI
changes that organizations will be conIronted with are identiIied which address human resource
management issues relating to global expansion and product specialization:
Convergence between mainstream Iirms and alternatives Iirms as their competitive
Iields overlap;
Categorisation oI active products into two types relative return mandates and absolute
return mandates, with growth particularly in the latter;
Increased specialisation, whether by asset class, risk level or investment style;
Consolidation oI Iirms, whether to Iill product holes, add capability, address
geographical diversiIication or to augment manuIacturing and distribution capabilities.
Watson & Wyatt outline the generic competencies that will be required to address the situation
in Diagram 19.1 below. They suggest that 'players can choose whether to concentrate on
mastering a single competency or whether to target a mix.
Diagram 19.1: Future competencies
183
5. Pressure for talent
On oI the greatest drivers Ior competitive advantage is the level oI talent that exists both at the
operational and management level oI pension Iunds. Compensation as always is a major Iactor
in the attraction and retention oI skilled labour, increasingly however non-compensation drivers
such as culture and associate development have come into the equation.
6. New food chain
Watson Wyatt anticipate that Iunds will create a more eIIective Iood chain`, as the area oI cost
control in particular attracts attention, with a view to improving the value proposition. As a
result oI the recent poor perIormance oI pension portIolios, Iund managers in the Iuture may
Iind themselves Iorced to sacriIice a portion oI their Iees in order to retain the business. On the
employment Iront, it is predicted that the trend in the outsourcing oI executive investment
expertise will continue, thus allowing the governing board to Iocus on issues oI strategic
importance.
} Srowth of a|ternat|ve strateg|es
1. New investment content
The shiIt in the Iood chain is visible in the emergence oI new investment content with the
promise oI higher eIIiciency. The use oI short selling, derivatives and leverage has become
more prevalent as pension Iunds move Iurther towards the provision oI solutions through
outcome-speciIied mandates. Strategies involving downside protection and the delivery oI
absolute return will come more to the Iore; so too will whole-journey solutions involving the
deployment oI an eIIective LDI approach.
2. The emergence of sustainable development as an investment principle
The environment and sustainability are moving up the agenda as institutional Iunds driven by
political policy and consumer demand apply responsible investing principles to their asset
allocation strategies.
3. Stabilizing strategies
Pension Iunds are currently taking less strategic risk and diversiIying their portIolios in order to
address the issue oI liabilities. The key task in developing an asset allocation strategy is to
examine what each asset class can deliver in relation to the Iunds liabilities. Each pension Iund
will thereIore design its own portIolio allocation in order to meet its liability structure. There is
thus a need Ior a clear mission with regards Iunding levels and commitment to paying pensions
to members, supported by a holistic and integrated investment strategy to achieve that mission.
Managers should measure risk relative to that mission, and in turn measure return relative to the
risks they are taking. In the event oI a downturn in the market, it is important that Iund
managers keep investors inIormed in order to prevent panic. An emphasis should be put on the
long term investment structure oI pension Iunds in order to reassure investors that similar
diIIicult trading periods have been overcome in the past.
It is necessary also to consider the level oI resources needed to complete the task. Pension
Iunds initially try to achieve their investment strategy goals within the governance budget. It
184
may however be better to agree in the Iirst instance on what it is that the Iund sponsor, manager
and trustees are trying to achieve and thereaIter agree on the governance budget that will allow
the manager to deliver the desired results. There is a need Ior a disciplined and structured
approach in order to select the opportunities that the Iund wishes to invest in, the managers they
wish to invest with, and the power to appoint the right investment advisor in accordance with
the problem they are seeking to address.
It has become a challenge Ior DB schemes in particular to overcome the hurdles oI the roller
coaster` market. They need to be Ilexible, in that tried and tested strategies that worked in the
past may not be successIul today. Some asset allocation decisions will add value to the Iund
whereas as others will inevitably detract. The aim should be to minimize the number oI
decisions needed to get the strategy right. Pension Iunds have delved into a wider range oI
assets which include bonds commodities, corporate debt, emerging-market equities, private
equity and hedge Iunds in their shiIt to match liabilities. These various asset classes have
diIIerent characteristics when it comes to matching or not matching liabilities. Bolitho oI
Goldman Sachs (2004)
1
observes that 'the great diIIerence between roulette in a casino and
pension-Iund investing, is that when investing in any asset class that shares in world growth
you get paid to take part. So, iI you turn up at the table and bet on every single asset class that
shares somehow in world growth, you are going to return a positive return over the long term,
assuming that the world continues to grow economically.
However, making demands or having unrealistic expectations oI the stock-markets as they
respond to market developments can be Iraught with danger. It may be necessary in times oI
uncertainty Ior individuals to increase contributions and Iund managers to reduce costs in order
that investors can look Iorward to a secure retirement. In a buoyant market, good returns seem
to cover all sins; however in a period oI low returns, cost management becomes more
important.
4. Rebalancing of pension funds
AIter its rapid growth in the last 10 years, the stock market no longer Ieels like the goose that
laid the golden egg`. The diIIering views oI Iund managers on the Iinancial crisis and which
path to choose may create potential Ior conIusion among trustees as they seek to make changes
to their asset allocation. DiIIerent managers employ diIIerent models in their rationale Ior
diversiIication over the short term. The current crisis demonstrates that markets are not eIIicient
and that active judgement has an important role to play. Those managers with strong research
departments that gather insights into asset classes will be the most successIul in terms oI
delivering a higher return Ior the same level oI risk or the same return at a lower level oI risk.
Having experienced a volatile investment climate over the last two years, Iund managers may
be tempted to make changes to the balance oI their portIolios in order to cope with the ever
changing economic and political environment. It is important in this situation not to close the
barn door aIter the horse has bolted`. Fund managers should consider any changes to be made
on a risk-adjusted basis, taking into account the risk involved against the potential return.
PortIolios cannot be repositioned with a single stroke; in order to change the existing asset
1
185
allocation model it is best to conduct scenario and stress-testing exercises on possible market
outcomes and how to cope with such situations.
As conditions on the ground change, so too should the strategic benchmarks oI Iund managers.
The degree oI uncertainty in the economy and its eIIect on the capital markets will have a
deIining impact on volatility and the potential Ior returns. Fortune oIten Iavors the brave; to this
end Iund managers may decide that being overweight in risky assets is preIerable as the
economy continues to recover. Some pension Iund managers have needed to actively reduce
equities and increase bonds in order to address solvency issues while others have allowed their
asset allocation position driIt out oI equities and into bonds by simply not trading and staying
on the sidelines. The process oI de-risking by reducing equity allocation needs to be measured;
however the speed at which recent adverse events in the capital market have taken place have
made this process anything but measured. Even a de-risking course oI action may have its
pitIalls; with governments Iacing a scenario wherein they may deIault on their debt, a situation
may unIold wherein the risk Iree` asset oI a Treasury bond is no longer risk Iree!
With the pension underIunding situation as it currently stands, assets will have to be worked
harder through the continued use oI alternative investments and increased diversiIication, in
order to meet liabilities. The emergence oI derivative instruments as a type oI get out oI jail
card` has greatly beneIited the industry in terms oI being able to hedge against risks. Hedging is
a useIul tool in the asset liability management and can be practised across all asset classes in
order to achieve targeted returns.
The challenge Ior managers is to decide at what stage to re-build risk allocations. Many Iund
managers like to boast oI success in delivering alpha; hedge Iund managers contest that as the
issue oI transparency is Iorced upon the Iund management industry there is more pressure on
them to reveal trade secrets and therein less chance to generate extra alpha`. It is unlikely
however that there is a secret Iormula which delivers excess returns Ior pension Iunds. Watson
Wyatt (2009)
1
argued that 'on the basis oI the last year`s perIormance Iigures, there appears to
have been too much beta being sold as alpha by hedge Iund providers, at too expensive a
price. It should be noted that hedge Iund managers are not the new alchemists that can turn
assets into gold. Every hedge has a transaction cost and an opportunity cost in terms oI possible
gains sacriIiced. Furthermore, there is also a counter argument which would suggest that being
in the right market at the right time is the surest way oI generating proIit.
Ultimately the challenge is to get a balance between the market risk, the beta, and the
individual mangers skill. The question oI how much active management to pursue is a matter oI
judgement Ior the respective Iund managers. It is necessary to be Ilexible in the application oI
active management as conditions on the ground are constantly changing, it is also important
that Iund managers are in possession oI a strong sponsor covenant that supports the risk
strategy. There were many investment opportunities Ior managers during 2009, with stock
markets having reached a Iloor during the Iirst quarter oI the year. Many pension Iund
managers were Iorced to sell assets due to the need to meet solvency requirements, leaving a
number oI mispriced assets in the market. When the world stock-markets bottomed out` the
pensions industry witnessed a change in sentiment once again with Iunds increasing their
1
Watson Wyatt (Ed.). (2009, January). Watson Wvatt 2009 Global Pension Asset Studv. Retrieved Irom http://www.watsonwyatt.com//
deliverpdI.asp?catalog200901-GPAS&idx.pdI
186
equity exposure as the year progressed. Such is the cyclical nature oI market movements and
their impact on strategic asset allocation.
As the pension crisis unIolded, the industry took advantage oI the opportunity to speed up the
transition Irom the DB to DC pension model. In the past, Iinal salary schemes had been the
gold standard oI retirement provision; this situation is beginning to change as employers seek to
oIIload their pension liabilities which have Ior so long been an albatross around their neck.
Throughout 2009 DB schemes were closed to new members across Europe. Many schemes had
been experiencing the 'iceberg eIIect, with inIormation and events that lurked below the
surIace having such a negative impact on Iunding levels that they Iinally Iorced the hand oI
sponsors. Although pension scheme trustees have long term horizons oI 30 50 years, their
corporate sponsors quite oIten have much shorter term horizons that are dependant on the
economic environment. The rise in pension Iund deIicits, coupled with the Iall in the market
capitalization oI the corporate sponsor has compounded the problem; as a result the employer
covenant has come under signiIicant pressure.
One solution to the problem has been Ior sponsors to seek buyers Ior the Iunds under
management. However, the phase oI pension buyouts over recent years by insurers and private
equity operators has all but Iizzled out. The search Ior suitors to buyout pension Iunds has now
become a perilous quest. Sutherland (2009)
1
observes that 'most oI the buyout organizations
set sail in diIIerent conditions when the sky was blue and no turbulence on the seas. They now
Iace a diIIerent situation with category Iive hurricane approaching; some will Iind it
exceedingly diIIicult to weather the storm.
In order to alleviate some oI the immediate pain, European regulators have allowed corporate
sponsors greater Ilexibility in terms oI meeting any shortIall in Iunding levels. However, the
monetary policy deployed by governments to combat the crisis has also had a detrimental eIIect
on the pension sector, with low interest rates suppressing returns on Iixed interest securities and
annuities. The situation is exacerbated in the UK where a policy oI quantitative easing, a
technical term Ior printing money, has wiped billions oI pounds Irom the value oI pension
Iunds. This policy may well have an inIlationary eIIect in Iuture years and therein increase the
liabilities oI pension schemes.
There is need Ior precision in addressing the acute problem oI the demographic time-bomb.
The situation oIIers little margin Ior error in terms oI achieving desired returns. In the past, the
Iund management industry behaved almost like a goldIish in a bowl; managers seemed to swim
once around the bowl, and when they completed the circle everything looked new again. It is
now time Ior sponsors to adopt a zero tolerance` approach to achieving a co-ordinated Iund
management strategy. This may involve a complete crackdown on all administration costs and
the capping or removal altogether oI perIormance Iees Ior managers.
II pension Iunds are to IulIil the purpose that they were initially set up to achieve, it may be
worth considering that they be ring Ienced or removed Irom the balance sheets oI companies`
altogether. In so doing there will be less temptation Ior sponsors to see the pension Iund as a
1
Sutherland, R. (2009, May 24). The Britons who can`t aIIord to become old . The Guardian. Retrieved Irom http://www.guardian.co.uk////
/britain-work-retirement-pensions
187
potential proIit centre. There is oI course no point in ring Iencing a black hole` aIter the event;
perhaps the only cure Ior the pension industry is a sustained period oI economic growth that
would hopeIully rescue company schemes that are mired in deIicit.
Although markets appeared a little more buoyant in the Iirst quarter oI 2010, this should not
mean that the momentum Ior continuous regulatory change should be stalled. A situation
wherein a general improvement in Iinancial markets covers up the cracks` is oI no beneIit to
all parties as European economies move out oI this recessionary phase oI the business cycle.
There have been signs oI an economic recovery during 2010, however it still seems a long way
Irom retrieving the situation with regards the underIunding oI pensions.
6} A v|ew on the future of pens|on schemes
No country for old men
The recent Iinancial crisis will pale into signiIicance when compared to the pension crunch that
awaits society iI the situation is not addressed by governments. It may be an unpleasant reality,
but the collective Iailure to provide Ior the Iuture will leave liIe bleak Ior many oI the retired in
European countries.
The state pensions currently have a mountain to climb as a result oI the increased public
borrowing needed to bail out the banks and jump-start the economy. The prospect oI an ever
greying population` that is retired and unproductive will place an increasing burden on the
young. One solution being contemplated by European governments is to increase the retirement
age Ior drawing state pensions Irom 65 to 67. Should governments go a step Iurther and raise
the retirement age to 70, retirees would Iind that their retirement income could be boosted by
an additional 30.
The other alternative is Ior EU governments to increase their eIIorts in establishing suitable
structures Ior individuals to save. The three pillar pension Iramework as outlined by the World
Bank encourages voluntary savings that supplement state pension systems. There is however no
'magic wand' that transIorms small savings today into a substantial retirement Iund tomorrow;
that idea was always Iool's gold. Governments, companies and shareholders have always
underestimated the real costs and risks oI pension Iunds.
One oI the key problems with the concept oI retirement provision is that the pension platIorm
itselI has evolved into a lucrative industry with lots oI cut and thrust` tactics being applied
which oIten lead to blood-stained Iloors. There is oI course no gilt-edged solution that will
guarantee commitments to pensioners in the years to come, however the blind pursuit oI wealth
creation through the application oI a survival oI the Iittest` approach to pension systems has
been proven to be a Iailure.
It is important to examine what the market needs in order to achieve good outcomes Ior society.
The Iormer chairman oI the Federal Reserve, Alan Greenspan in 2007 spoke oI 'irrational
exuberance in terms oI the creation oI an unsustainable asset bubble. UnIortunately when
markets are opaque due to the absence oI regulation, the pursuit oI selI interest may result in
everyone being worse oII and lead to serious malIunction oI the system. It is thereIore up to the
policymakers to instil conIidence in the market by having the necessary checks and balances in
place so as to prevent systemic risk Irom developing. Ultimately it is not the capitalist system
188
which is to blame but moreover the people who are in charge oI policing it Ior the beneIit oI
society.
WolII (The Guardian 2009)
1
reIers to the inevitability oI capitalism's economic cycle. When at
at the top oI a cycle, politicians and economists boast that they have Iinally cracked it and
achieved sustainable growth. But when at the bottom we are told not to worry, as the cycle will
run its course and the good times return. The miracle oI the Iree market was Iamously captured
by Adam Smith: "It is not Irom the benevolence oI the butcher, the brewer or the baker, that we
expect our dinner, but Irom their regard to their own selI-interest. We address ourselves, not to
their humanity but to their selI-love, and never talk to them oI our own necessities but oI their
advantage." The argument that most people will always opt to do what is in their best interest
is not a new one; it is important however not to conIuse this with the greed is good` mantra.
During another one oI his reIlections on the Iinancial crisis, Alan Greenspan observed that
'human nature is Iundamentally Ilawed; with this in mind it is necessary that European
governments ensure that the market does harness selI-interest Ior general well-being through
governance and regulation oI the system.
Summary of research findings on concerns for the future of the pension scheme
The greatest threat Ior the Iuture perceived by pension scheme management was that related to
the ageing population and longevity risk. 31 oI respondents considered this their primary
concern with a Iurther 15 expressing the need to Iocus on liability driven investment
strategies in order to meet pension commitments (see Diagram below). Risk management
processes were also a key Iactor with 28 oI those questioned having this high on their list oI
issues. Administrative challenges were a point oI issue expressed by 15 oI respondents with a
Iurther 10 concerned about the commercial Iuture oI the sponsoring entity.
Diagram 19.2: Future concerns for pension schemes
Concerns for the future of the scheme
b. Longevity risk 19 31.15
d. Risk management process 17 27.87
c. Need for liability driven
investment
9 14.75
a. Administrative challenges 9 14.75
e. The commercial future of
the sponsor
6 9.84
f. None of the above 1 1.64
Total: 61
1
WolII, J. (2009, July 7). Greed is good (sometimes); but regulation is better. The Guardian. Retrieved Irom http://www.guardian.co.uk////
/wolII-recession-marx
189
Part VI
Chapter 20 The opportunity for consulting services
It is important that pension Iunds source new talent and entice specialists into the industry. The
major consulting Iirms have developed their own skills to meet the growing demand Ior
services Irom pension Iunds. This has been achieved through hiring proIessionals that
specialize in swaps and derivatives, ex hedge Iund managers and developing researchers,
actuaries and CFA investment specialists in-house. However, the best pension consultants don`t
necessarily market their skills or put themselves in the shop window`. A key issue Ior the
pensions industry is one oI knowledge management and the availability oI expertise in the
marketplace. It is in this area that a Iorward looking pensions consulting group can step up to
the mark with its oIIer to Iill the knowledge gap.
As a result oI the ongoing problem with underIunded pensions, there is now more than ever a
demand Ior proIessionals that possess the specialized skills necessary to deliver value to
schemes. The recent Iailure in perIormance oI pension Iunds would suggest that the industry is
indeed Iacing a shortage oI talent; therein lies the opportunity Ior new entrants to the market.
The consequences oI making errors in terms oI governance and asset allocation can have
drastic repercussions Ior all stakeholders involved in a pension Iund. It makes good sense
thereIore Ior pension trustees to seek outside assistance. Consultants have thus emerged as an
integral part oI the value proposition, providing intellectual capital in a specialist advisory
capacity.
In order to explore the opportunities Ior a pension consultancy in greater depth, a series oI
theoretical models originally introduced by Michael Porter in his book Competitive Advantage.
Creating and Sustaining Superior Performance (1985)
1
, are applied to an existing Paris-based
company named Axis Strategy Consultants`. Among the beneIits that consultants can oIIer
pension scheme stakeholders, are operational expertise, innovation, customer relations
management and ownership oI responsibility. The attributes oI this value proposition can be
measured and monitored on a balanced scorecard`, an issue which is addressed later in this
chapter.
A} Pens|on funds - Va|ue cha|n
Porter`s value chain` oIIers a systematic means oI displaying & categorizing events Ior the
pension Iund industry. It also highlights the positioning oI pension consulting / advisory groups
in the wider scheme oI pension Iund activities.
The aim oI a consultancy group is to research and explore opportunities Ior the pension Iund to
add value to schemes members by perIorming activities in a diIIerent or better way than
competitors. It is Ior the consultancy group to advise the pension scheme sponsor on how best
to develop uniqueness or advantage to the Iund with a view to delivering a greater margin oI
return and meeting ongoing commitments to members.
1
190
The diagram below outlines the various upstream and downstream activities involved in the
process oI pension Iund management.
1. Pension scheme development involves the structure and design oI the pension plan on
behalI oI members. As discussed in Part I, this may involve the selection oI a DB plan,
A DC plan; or alternatively a hybrid version oI the two.
2. Administration oI the scheme will involve a series oI legal and operational activities
that include
Legal contract requirements;
Underwriting requirements;
Regulatory requirements;
Liaison with governing Iiduciaries such as trustees and custodians;
Liaison with tax authorities;
InterIacing with the plan sponsor and plan members.
3. Investment management and risk management activities can either be conducted in-
house by the pension Iund or outsourced to Iund management specialists. A number oI
committees and advisory groups are oIten involved in the process in order to ensure that
every eIIort is being made to meet the pension scheme commitments.
4. Marketing and distribution activities would take place internally and externally in terms
oI promoting the pension product to existing members and interIacing with regulatory
and government bodies. Communication would be conducted through publications,
mediators and independent experts. The distribution oI the pension products would be
through recognized international vehicles such as IORP`s in the case oI pension Iunds,
or those schemes that comply with Solvency II regulations in terms oI insurance Iunds.
5. IT support and customer service activities will provide scheme members with a Ilow oI
inIormation that keeps them Iully inIormed oI developments with regards their pension
plan beneIits in a timely Iashion.
Diagram 21.1: The pension industry vaIue chain
Source: Adopted from Porter, 1980
190
that include
190
that include
191
A support inIrastructure is also in place that ensures pension schemes operate to the beneIit oI
their members and in accordance with local and international regulation. These supporting
activities include the Iollowing:
1. Trustees The ever-changing economic environment and the introduction oI new
legislation aIIecting pensions makes the role oI the trustee increasingly important. There
is a growing emphasis on trustees to add value both to beneIiciaries and to the
companies that sponsor the pension scheme. One such area is in relation to investment
management practice and the protection oI schemes Irom Iinancial risk taking. The
trustees` role is thereIore to ensure that due diligence is employed in the management
process.
Quite oIten the aims oI investment managers and advisors and those oI the trustees have
conIlicting objectives. The goal oI the pension Iund trustee is to meet the commitment
oI paying pensions to the sponsor`s members; the goals oI the agent however may be
more geared towards the generation oI Iees. It is important thereIore that trustees use
their inIluence and control to steer agents in the direction that beneIits the interests oI
members. Watson Wyatt (2009)
1
note that: 'trustees need to work harder in order to
understand the motivations, incentives and alignments oI interest that prevail in the
investment industry. They add that 'remuneration is a powerIul tool, and that trustees
should exercise more control over what sponsors spend and where they spend it.
2. Technology development There is a requirement Ior the continuous development oI
business processes in order to ensure that the core operations oI the value chain are
suIIiciently supported. Technology can be leveraged in combination with other support
services to achieve superior perIormance and results. In terms oI operational eIIiciency,
technology can help induce productivity improvements through the standardization oI
processes and control oI administration costs. It can also be instrumental in the delivery
oI customer service through the communication oI timely and accurate inIormation on
accrued beneIits to plan members.
3. Consulting groups Pension schemes do not have the expertise or resources to manage
all the necessary activities in-house. To this end they employ various investment
managers, consultants and advisors to IulIill specialist Iunctions. It is in this arena that
a pension`s advisory group can make a signiIicant contribution to the optimization oI
the value chain.
4. Regulatory authorities There is a growing demand Ior improved governance oI
pension Iunds to ensure a greater Iocus on the requirements oI members. Regulatory
authorities seek to Iind the correct balance between satisIying the concerns oI
policymakers and addressing the needs oI retirees. It is important thereIore to have a
Iunctioning regulatory apparatus that Iacilitates wise investment through the application
oI sound risk management tools.
1
Watson Wyatt (Ed.). (2009). Defining the pension and investment Industrv of the future. Retrieved Irom
http://www.watsonwyatt.com/////2.pdI
192
The objective oI regulatory reIorm is not to add new levels oI bureaucracy to existing
systems, but moreover to lay the necessary groundwork Ior desired outcomes Ior
society to be achieved. As a result oI changes in regulatory systems, pension Iunds are
being Iorced to show greater transparency and inIorm plan members oI any changes in
the Iunding status. This increased transparency inevitably will come to the attention oI
investors, administrators, managers and agents, and thus have an impact on how
governance is conducted.
Competitive strategy: Analysis of the pension-consulting industry and competitors
A model Ior analyzing the structure oI industries was developed by Porter (1985)
1
, wherein
he argued that rivalry among Iirms in industry depends upon Iive Iorces: the potential Ior
new competitors to enter the market; the bargaining power oI buyers and suppliers; the
availability oI substitute goods; and the competitors and nature oI competition. These
Iactors are outlined below in Diagram 22.2.
Diagram 22.2: Porter's five forces
Source: Porter, 1985
1. Forces driving industry competition
Porter highlighted that "the essence oI Iormulating competitive strategy is relating a company
to its environment. Although the relevant environment is very broad, encompassing social as
well as economic Iorces, the key aspect oI the Iirm's environment is the industry or industries in
which it competes. Industry structure has a great inIluence in determining the competitive rules
oI the game as well as strategies potentially available to the Iirm. With this in mind, a new
entrant to the European pension consulting business should conduct a comprehensive analysis
oI the underlying Iorces, attractiveness, and success Iactors that determine the structure oI the
1
192
1
, wherein
1
192
1
, wherein
1
193
industry. The purpose oI this exercise is to gather suIIicient inIormation with which to
Iormulate an eIIective strategy that makes the most eIIicient use oI the limited resources oI the
small business, and in so doing enable it to correctly position itselI as a service provider that
oIIers value.
The major players in the European corporate pensions sector include IORP`s, insurance
companies, mutual Iunds, unit trusts, bond Iunds, Iixed interest securities and a range oI
alternative asset managers including hedge Iunds and private equity. It is indeed quite a
populated arena, which reIlects the demand Ior expertise Irom outside consultants.
Porter outlined Iive Iorces that determine the competitive intensity and therein attractiveness oI
a market. Understanding the Iorces at work in an industry is an important Iactor in the
development oI strategy. These Iorces are continuously shiIting in both the micro and macro-
environment and have an impact on the ability oI the company to serve its customers and make
a proIit. Porter advocated that 'the goal oI competitive strategy Ior a business unit in an
industry is to Iind a position in the industry where the company can best deIend itselI against
these competitive Iorces or can inIluence them in its Iavor."
a) The bargaining power of buyers
The buyers in this particular marketplace are the pension Iund sponsors. In order to convince a
sponsor oI the attractiveness oI the company services, it is necessary in the Iirst instance to
develop a relationship with the guardians oI the scheme i.e. the trustees. Like most business,
respect cannot be commanded in the pension industry, but moreover has to be earned over a
period oI time through results and delivery oI service. In the pension arena, both the Iund
perIormance and charging structure are key criteria Ior sponsors in the selection oI Iund
managers, advisors and products.
Pension Iund sponsors can exert pressure on consultancy businesses by playing competitors oII
one another therein negotiating lower Iees or additional services. They can also insist on more
stringent perIormance indicators in terms oI the measurement oI success. An additional tool
which sponsors employ to create leverage over Iund managers and consultants is the use oI
service mandates that only last Ior a Iixed three to Iive year period; however the term oI such a
lock-in` period also creates high switching costs iI sponsors wish to move to competitors.
Not all oI the power resides in the hands oI the buyer. The range oI suitable pension products
currently on oIIer to sponsors` are sophisticated in nature, due to the technical requirements oI
Member State pension regimes; they are also limited in number. The absence oI a standard
product that could be used across borders thus leaves corporations dependent on outside advice.
b) The bargaining power of suppliers
Suppliers in the Iorm oI Iund management groups have limited power as there is a wide range
oI asset management providers in the pension arena. As a pension portIolio consists oI a
mixture oI asset classes, each pension Iund will account Ior a small portion oI the asset
management groups` business. The availability oI substitutes in the asset management business
and the low switching costs associated with changing Iund managers thus impose limitations on
the power oI the service supplier.
194
However, the absence oI market inIormation and specialized knowledge relating to pension
systems within corporations creates a need Ior consultants. This lack oI in-house talent and
resources make it diIIicult Ior many sponsors to practice any Iorm oI backward integration in
terms oI the distribution chain and hence increase the demand Ior outside services.
An important Iactor which tends to bolster supplier power is the high exit barriers oI
withdrawing Irom a pension. In terms oI insurance-based products there are quite oIten
signiIicant penalties involved in the early withdrawal oI a company Irom an established
scheme. This coupled with high establishment costs acts as a disincentive to any scheme
sponsor wishing to change supplier.
There is a greater concentration oI power in the hands oI pension consultancy groups with a
Iew major players dominating this particular area. This power can oIten act as a signiIicant
hurdle to a small business in that many corporations opt Ior the established brand name when
deciding on whom to use as a consulting service. The building oI reputation in the pension Iield
is paramount to securing a lasting tenure as an advisor. To do so, the small business needs to
demonstrate that it can oIIer a sustainable competitive advantage whether through product,
knowledge or extended services.
c) Intensity of competition
The rapid growth oI pension Iunds has led to new players Irom the asset management industry
entering the arena. The traditional liIe insurance companies that once had a monopoly on
pensions have now been joined by a myriad oI Iinancial institutions including mutual Iunds,
and alternative asset managers. Because oI the growth in the pensions market, the playing Iield
has opened, with advisory groups oIIering diIIerentiated services that Iacilitate the integration
oI Iunctions, promise cost reduction, and avoid bureaucracy and the overlapping oI tasks.
Being in possession oI a pension is now a necessity Ior everyone and has transIormed pension
services into a lucrative and attractive industry Ior many businesses. As in every business
environment, a company tends to beneIit Irom having a constant set oI competitors. The
ongoing competition between competitors may come in the Iorm oI the level oI Iee charges,
advertising campaigns, or expanded service oIIerings.
The pension consultancy arena is populated by a small number oI players that possess
specialized skills and have built up a reputation that has allowed them to create a large amount
oI brand equity. Through their network oI international oIIices across Europe these players
have been successIul in the development oI close relationships with international pension
sponsors. This has leIt them in a dominant situation when it comes to protecting the
marketplace Iorm new entrants, as they beneIit Irom both economies oI scale in terms oI the
reduction oI Iixed and operating costs, and economies oI scope wherein a successIul pensions`
solution or approach can be applied across borders.
d) Barriers to new entrants
For a company seeking to become a new player in the corporate pension arena, the ease oI
entry is a key Iactor in being able to gain a Ioothold in the market. As the market Ior corporate
pensions is quite sophisticated, there are a number oI barriers to success. In addition, there is
always the hurdle oI actually possessing the required knowledge and skill set to make a valued
contribution to the pension Iund sponsors. Running concurrent with this would be the need Ior
appropriate qualiIications and licensing in order to comply with industry regulations.
195
Other barriers to market entry Ior a small consultancy would include economies oI scale and
high capital requirements. The major players in the pension advisory business such as Towers
Watson and Mercers have strong brand equity and a long history in various Iorms oI
management consulting. Having invested a lot oI capital into the market, it is likely that
existing competitors will react strongly against new entrants in order to limit access to the
channels oI distribution.
One beneIit oI working in an industry that is diIIicult to enter is that sources oI competitive
advantage tend to last longer. It is thus imperative that the new entrant have some superior
skill-set that will diIIerentiate it Irom other players and enable it to buy some time in order to
get a Ioothold in the marketplace.
As there are a range oI consultancy groups available to the sponsor, it is important Ior new
players in the market to position themselves as a suitable alternative choice. A new player will
Iind access to buyers limited as a result oI high switching costs. It will also be diIIicult to
compete when Iinancial resources are limited; it is all the more important thereIore that a small
company employ a niche strategy in terms oI market entry. There is no point trying to target the
same blue-chip companies as the major rivals; Axis Consultants simply do not have the
resources in terms oI manpower to do so. Alternatively, the market segment oI companies with
pension schemes with less than t1bn oI assets under management should be the target, as these
may be a less attractive proposition Ior the bigger players.
e) Regulations on new entrants
There are various governmental social and labor restrictions on what Iunds or advisors can be
used in a given Member State. There is also a plethora oI rules and regulations that seek to
license activities in the marketplace; this regulatory Iramework has been put in place to protect
the rights oI pension Iund members. Markets leIt to their own devices will tend to monopolies;
.such concentration oI power however can lead to overpricing and unnecessary risk taking. It is
important thereIore to lower the barriers to entry so as to encourage Iree markets and pave the
way Ior new players onto the stage.
f) Threat of substitute products
The pension industry can never rest on its laurels` as there are always substitute products in the
marketplace that limit potential returns by placing a ceiling on the prices suppliers can
proIitably charge. Substitute pension products in the Iorm oI asset pooling vehicles` oIIer a
more simple structure Ior sponsors and Iund managers alike as they are not burdened with too
many restrictions and constraints. Asset pooling in its basic Iorm involves moving assets held
under separate national Iunds into a series oI large central Iunds. These asset platIorms are less
time-consuming and expensive in terms oI their legal and operational Irameworks and oIIer a
more uniIorm approach towards asset management whilst promoting eIIiciency.
Substitute service opportunities are also being created in the consulting arena, where small
business are leveraging IT capabilities in order to accumulate reservoirs oI knowledge and
specialized skill sets.
196
2. Industry attractiveness and success factors
Cook (1995)
1
explained that "industry attractiveness is the presence or absence oI threats
exhibited by each oI the industry Iorces; the greater the threat posed by an industry Iorce, the
less attractive the industry becomes." He argued that small businesses should attempt to seek
out markets in which the threats are low and the attractiveness is high. Understanding what
industry Iorces are at work enables small business owners to develop strategies to deal with
them. These strategies, in turn, can help small businesses to Iind unique ways to satisIy their
customers in order to develop a competitive advantage over industry rivals.
Success Iactors are those elements that determine whether a company succeeds or Iails in a
given industry. Examples oI success Iactors in the pensions industry include quick response
to market changes, a complete product line, Iair prices, excellent product quality or
perIormance, knowledge management, a good record Ior deliveries, solid Iinancial standing,
or a strong management team. By identiIying success Iactors, it is possible to Iocus on areas
that will yield competitive advantages. The new entrant to the market needs to Iirstly
determine whether or not the company possesses each success Iactor identiIied, and
thereaIter decide whether the company can and should develop additional success Iactors.
Having decided on these Iactors the consultancy needs to have a matrix oI knowledge, ideas
and strategies ready to oIIer.
With the increasing awareness oI problems associated with the demographic time-bomb`, the
door has been opened Ior pension consultants and asset managers to introduce a leaner and
more competitive model to manage pension schemes. Competition is healthy Ior business in
that it creates both eIIiciency and eIIectiveness in products and delivery systems. Such rivalry
will stimulate the technological development oI systems that are designed to deliver the
necessary income to meet retirement scheme commitments. Whoever gets there Iirst will have
the largest share oI the pie; ultimately, the real winners will be the pension plan members.
3. Importance of industry analysis
"Once the Iorces aIIecting competition in an industry and their underlying causes have been
diagnosed, the Iirm is in a position to identiIy its strengths and weaknesses relative to the
industry (Porter 1985)
2
. Porter adds that "an eIIective competitive strategy takes oIIensive or
deIensive action in order to create a defendable position against the Iive competitive Iorces."
The choice oI strategies include positioning the Iirm to use its unique capabilities as deIense,
inIluencing the balance oI outside Iorces in the Iirm's Iavor, or anticipating shiIts in the
underlying industry Iactors and adapting beIore competitors so as to gain competitive
advantage.
To develop a competitive strategy Ior the pension consulting sector it is necessary to conduct
an analysis oI the organization. Porter proposed that companies consider the key internal and
external Iactors in order to determine the limits oI what can be accomplished. Such internal
Iactors would include an analysis oI company strengths and weaknesses along with the
personal values oI the key implementers, whereas external Iactors would Iocus on industry
1
Cook, K. J. (1995). The AMA Complete Guide to Strategic Planning Ior Small Business. American Marketing Association.
2
197
opportunities and threats and any broader societal expectations. Diagram 22.3 below illustrates
the interdependencies between these Iactors in the development oI a competitive strategy.
Diagram 22.3: Context for competitive strategy formuIation
6} 6ompet|t|ve strategy for Ax|s pens|on consu|t|ng serv|ces
1. Internal factors
Company strengths play a central role in the success oI a Iirm. It is necessary to identiIy key
areas oI superior skill or ability that diIIerentiate the company Irom that oI the competition.
ThereaIter the company should seek to combine these strengths with opportunities in the
outside environment in order to develop a strategy that creates competitive advantage. It is also
important to understand the strengths and weaknesses oI rivals in the Iield.
An evaluation oI the skills oI Axis Pension Consultants relative to competitors would
include the Iollowing internal Iactors:
Strengths
The brand name Axis Strategy is synonymous with the alignment oI resources;
ProIessionally qualiIied personnel that specialize in pension products and
administration systems;
International experience oI personnel ;
Role as an intermediary Ior a network oI Iinancial institutions including banks,
insurance companies and Iund management groups;
Links with specialist asset management groups such as hedge Iunds;
Range oI pension products at disposal;
Determination oI the company executives to be both quality and service driven;
Finely-tuned communication and presentation skills oI key personnel;
Flexible work practices;
Active promotion oI sustainable development and environmentally Iriendly Iunds;
197
1. Internal factors
Strengths
197
1. Internal factors
Strengths
198
Database systems specializing in benchmarking the perIormance oI Iund managers.
Weaknesses
A small operation that oIIers boutique services;
Financial constraints in terms oI resources;
The company does not beneIit Irom any economies oI scale.
2. External factors
External Iactors determined by the pensions industry and broader environment generate a range
oI opportunities and threats Ior players in the marketplace. These Iactors are deIined by the
competitive environment and include risks and reward systems, the impact oI government
policy, social concerns, etc. Understanding the industry and anticipating its Iuture trends and
directions provides a company with the necessary knowledge to react and control their relevant
portion oI that industry. By identiIying the threats and opportunities Iacing the businesses, an
organization can Iocus on what is needed to develop unique capabilities that could lead to a
competitive advantage.
The Iollowing external Iactors pertinent to Axis Pension Consultants would include:
Opportunities
The correction in the stock-market has increased momentum Ior change;
Greater industry Iocus on added value;
PerIormance Iees oI competitors have come under the spotlight;
Demand Ior risk management expertise;
Public awareness oI global warming and a developing trend towards sustainable
asset management;
Niche marketing and the emergence oI specialist 3
rd
party marketers;
Growing inIormation technology and communication capabilities;
More open economies in Eastern European markets.
Threats
Government regulation;
Member State Social and labor law;
Growing competition.
Diagram 22.4 Irames the major strength, weakness, opportunities, and threats Iaced by Axis in
a SWOT Iormat.
199
Diagram 22.4: SWOT anaIysis for Axis
Strategic fit
A pension consultancy will act as a broker between the available schemes in the marketplace
and the plan sponsor. Consultants base their value on independent advice; it is important
thereIore that the preIerred products and Iund managers reIlect impartiality in the choice oI
selection and are recommended on the basis oI merit.
The challenge Ior the new entrant would be to develop a niche market Ior its services through
the accumulation oI specialized knowledge on pension products, and risk management
processes with a view to the creation oI a reservoir oI inIormation Ior both buyers and
suppliers. With an ever-changing environment, a pension consultancy at the cutting edge oI
inIormation technology and product innovation can add signiIicant value to sponsors; the task
thereaIter would be to generate awareness and entice potential customers to avail oI these
services. Competitive advantages are not Iound in one complete box; it is necessary thereIore to
look Ior opportunities to improve services at the intersections. This may be easier achieved
through collaboration with other players in the Iield.
0} Performance and compet|t|ve advantage
There is a need to measure critical success Iactors` and the core competency` oI the company
in the various activities oI the value chain. The roots oI perIormance and competitive activities
lie in the assets oI the organization. Intangible assets such as the resources oI the company
would include Iinancial, technological, human & organizational resources. These resources
when combined with the capabilities oI personnel are then transIormed into areas oI core
competences Ior the Iirm (Hollenson 2008)
1
. The objective is to excel in a number oI value
1
Hollenson, S. (2008). Global Marketing: A Decision Oriented Approach. FT. Prentice Hall; Harlow, England.
-CpporLunlLles
-SLrengLhs
Cuallfled personnel
lnLernaLlonal experlence
Agency neLwork
SophlsLlcaLed l1 sysLems
uemand for experLlse
Lmphasls on added value
Advances ln l1
1rend Lowards susLalnable
asseL managemenL
199
Strategic fit
1
1
-1hreaLs
-Weaknesses
Cuallfled personnel
lnLernaLlonal experlence
Agency neLwork
SophlsLlcaLed l1 sysLems
Small operaLlon
llnanclal consLralnLs
no economles of scale
8egulaLlon
Member SLaLe s
Soclal & labour law
Crowlng compeLlLlon
uemand for experLlse
Lmphasls on added value
Advances ln l1
1rend Lowards susLalnable
asseL managemenL
199
Strategic fit
1
1
200
chain activities that deliver tangible competitive advantages in comparison to competitors, with
those advantages being reIlected in superior perIormance as an end product (see Diagram 22.5
below).
Diagram 22.5: Performance and competitive advantage
Tangible assets
Intangible assets
Source: adapted from Hollensen 2008
In order to win the customer`s Iavor it is necessary that the new entrant cultivates perceived
value in comparison to the relative costs oI competitors. This may be diIIicult to achieve given
the Iinancial and operational constraints that a small company is subjected to. Nevertheless the
consulting group needs to be able to oIIer a skill-set that spans across all sections oI the value
chain with actors well versed on all aspects oI product, legislation and asset management as
well as sales, distribution and marketing. To command attractive Iees Ior services provided, the
company will have to provide high value or risk being driven out oI market. It may be
necessary thereIore Ior the company to use the leverage oI other competitors` skills in some
Iorm oI partnership arrangement.
It is important that the consultancy group knows what it stands Ior and controls all aspects oI
communications with the aim oI generating a positive image oI the company. To this end there
is a need to Iocus on the values oI the company, therein developing a passion Ior quality
services and creating a culture oI openness and accountability. The challenge is to establish a
reputation Ior objective advice and consistency in the delivery oI solutions. By adopting a
culture oI hard work, determination and good timing, opportunities will be created and the
likelihood oI success enhanced.
200
below).
Tangible assets
Intangible assets
200
below).
Tangible assets
Intangible assets
201
1. Service provider dependency
One oI the biggest obstacles in the business Iield is that many potential customers are
dependent on existing service providers. These customers have a tendency to be locked into
traditional or past practices or preIerences even iI better alternatives are available.
It can be a signiIicant drawback iI the larger consultancy groups have such control over clients
in terms oI the resources available that enable them to dictate direction to the market.
Customers understand that having more than one supplier in a competitive environment helps
to keep prices low and perIormance high. They are invariably open to new ideas and better
service levels; the key issue is how to bring the proposed enhanced services to the attention oI
the marketplace.
2. A customer-centric approach to strategy
There are opportunities Ior a small, Ilexible organization with a penchant Ior consumer Iocus in
the marketplace. Drucker (1968)
1
argued that 'an enterprise`s purpose begins on the outside
with the customer; it is the customer who decides what a business is, what it produces and
whether it will prosper.
The main ingredient oI a customer-centric approach is to create a positive consumer experience
both at the point oI sale and post-sale. Such an approach allows a company to add value by
diIIerentiating themselves Irom competitors. The customer-centric concept begins with the
ability to listen to customers, determine what they really want and then turn that into something
valuable. This philosophy is built on three key Iactors: diIIerentiation, solutions and integrated
business processes in the Iorm oI an inIormation well` as illustrated in Diagram 22.7 below:
Diagram 22.7: A customer-centric approach
1
Drucker, P. (1968). The practice of management. Great Britain: Pan Books.
Customer-
centric
innovation
DiIIerentiation
The
inIormation
well
Solutions
202
The gap in levels oI service between the large and smaller pension consultancies in terms oI
access to inIormation and processes is shrinking as a result oI technological development.
When everyone in the market has access to the same knowledge and products, the key success
Iactor invariably comes down to the people that are involved and how they manage the systems
and communicate to customers. Axis can diIIerentiate itselI Irom competitors through being
consistent in its delivery oI best practises, and by maintaining open lines oI communication
with a view to cultivating better relationships.
3. The information well
UnIortunately brands with the largest resources are able to shout the loudest. In order to occupy
a niche position in the pension services market it is necessary to have something diIIerent to
oIIer. This can be achieved through the development oI a pension platIorm that allows Axis to
act as a gatekeeper, or aggregator oI inIormation. The objective is to empower pension
sponsors by oIIering access to inIormation at reasonable cost. The task oI the pension platIorm
is not to reboot existing systems with some new whistles and bells` attached. Moreover it is
about creating a renaissance in the design oI a progressive pension planning system, which
draws together all the various threads oI inIormation and oIIers sound advice that actually adds
value to retirement schemes.
The development oI an interactive Iorum that takes the pulse oI the pension sector through the
regular polling oI opinions and the use oI social media tools such as e-newsletters, blogs,
podcasts etc will help Axis keep sponsors inIormed about pension developments and bridge the
gap in service capabilities between the small and larger consultancy. Through such integrated
business processes and the application oI modelling techniques, Axis can oIIer tailor-made
solutions to clients.
4. Sources of competitive advantage
Should Axis seek to make a signiIicant impact in the pension consulting marketplace, it will
also need to determine its` source oI competitive advantage. In selecting a core strategy, it may
be useIul Ior Axis to give consideration to the Iollowing Iive areas:
Service diIIerentiation
The company needs to consider what exactly it can oIIer in its` value proposition that is
diIIerent in terms oI product or service.
Customer service and user support
While it is necessary to understand the needs oI the customer and design products and services
to satisIy those needs, the new entrant should not overlook the value oI ongoing support iI it
seeks to promote a customer-centric approach.
Price
By putting an emphasis on price, Axis hopes to encourage greater transparency in the pension
services arena. Price can be used as a tool to incentivize customers to purchase the market
oIIering. The challenge over time is to establish the price that the consumer is willing to pay Ior
203
service, which will in eIIect be a measure oI its value. This strategy requires a Iocus on
servicing economies, value chain management and investment in marketing and logistics.
Innovation
Ideas without organization result in chaos; however an organization without ideas can be
sterile. The big winners in the pension services business will be those companies that create
innovative pension products and associated platIorms, and acquire and manage knowledge
eIIectively. Drucker
1
deIined innovation as 'the speciIic Iunction by which the entrepreneur
either creates new wealth producing resources or endows existing resources with enhanced
potential Ior creating wealth. Alternatively, innovation is the eIIort to create purposeIul,
Iocused change in an enterprise`s economic or social potential.
For innovation to be purposeIul and systematic it is necessary to analyse the sources oI new
opportunities. Innovation can be both conceptual and perceptual; it is thereIore important to
observe what is actually happening in the marketplace and to establish what exactly are the
needs oI existing and potential customers` in terms oI product and service. This Iocus on
customer needs should not only be Ior the short term, but also Ior the long term. Interaction
and dialogue with the customers is thus the cornerstone oI establishing the value proposition`.
5. The value model of Axis Strategy Consultants
In order to be eIIective, any new product or service oIIering will have to Iill a gap in the
marketplace that satisIies customer needs. The ability to pinpoint the value oI a product or
service to one`s customers is oI great importance. Many customers oIten understand their own
requirements in terms oI associated costs but do not necessarily know what the value oI
IulIilling those requirements is.
It is essential thereIore to develop a shared understanding oI what actually constitutes value in
the pensions industry. To pension consultants such as Axis this lack oI understanding is an
opportunity to demonstrate the value oI services they provide and therein help customers make
smarter purchasing decisions. Value is oIten associated with the economic and social beneIits a
customer receives in exchange Ior the price it pays Ior a market oIIering. By determining the
key Iactors that pension Iunds associate with a valued service, the consulting group will be able
to use such knowledge to tailor supplementary services, programs and systems in addition to its
current market oIIerings. This new knowledge can also be integrated into the marketing eIIort
to obtain new customers and help sustain existing client relationships.
Axis oIIer a wide range oI pension consulting services on an independent and proIessional
basis with a view to the provision oI tailor-made` solutions to clients. The consultancy has
built up considerable expertise on international corporate pensions and associated regulation.
This enables clients to have access to technical skills and inIormation speciIic to their
requirements.
The superior market knowledge oIIered by Axis consultants can have signiIicant Iinancial
impact on the operations oI its customers; this added value must be brought to the attention oI
potential and existing clients in order that they show Iavour to the services oI Axis. To achieve
1
204
this objective, it would be helpIul to develop a customer value model which clearly highlights
the Iull range oI beneIits related to the services on oIIer.
The service is designed to give guidance on the areas outlined in Diagram 22.8 below:
Diagram 22.8: VaIue modeI for Axis pension consuIting services
A competitive advantage is something that a Iirm can do that rivals cannot match; it either
generates higher demand or leads to lower costs. In the case oI Axis, its` core competence area
is that oI having superior market knowledge. The challenge Ior the company is to leverage this
advantage in order to coerce competitors into sharing a piece oI the market in pension advisory
services.
6. Five sources framework
Porter (1998)
1
recommended an alternative to the Iive Iorces` approach to competition; namely
a Iive sources` Iramework. Where the Iive Iorces model Iocused on squeezing maximum
competitive gain out oI the context in which the business is located, the Iive sources Iramework
emphasized the role oI cooperation rather than competition between industry participants. The
objective to gain collaborative advantage can be Iound in the Iollowing liaisons:
Horizontal collaborations;
Vertical collaborations;
Selective partnering arrangements;
Related diversiIication alliances (with complements and substitutes);
Unrelated diversiIication alliances.
1
Porter, M. E. (1998). Competitive Strategv. Techniques for Analv:ing Industries and Competitors. Free Press.
Product and strategy
Creation oI structured
pension vehicles
International DB and
DC product solutions
InIormation and
assistance on technical
concepts
Strategic Planning
Investment consulting
Manager selection and
evaluation
Asset allocation
Asset liability
modelling
Sustainable asset
management
PerIormance
measurement and
benchmarking
Governance
Interpretation oI new
legislation
Use oI Iiduciary
management
Scheme governance
and best practise
Risk management
205
Having proven areas oI strength, Axis would be an attractive proposition as a partner in the
pension consulting arena. With expertise in the specialized area oI pension products and
structures, Axis would seek to exploit synergies with partners that are strong in the Iund
management area. SigniIicant cost-savings can be achieved Ior pension sponsors should Axis
collaborate with other players in the marketplace. Additional advantages oI collaboration would
include revenue enhancement through the cross-selling oI services, and the realization oI
economies oI scale. The ability to develop services through a systematic blending oI ideas and
inIormation will be critical to the success oI Axis. As in all collaborative situations when Iaced
with a number oI independent thinkers, the challenge is to have a consensus oI opinion in order
to Iind a coherent way Iorward. Such a consensus with independent teams can only be achieved
by taking a clean sheet` approach to a shared strategy and inviting all parties to make their
views heard at the outset.
E} enchmark|ng for pens|on adm|n|strat|on systems
Having positioned itselI as a niche service provider, it is necessary Ior Axis to employ some
Iorm oI benchmarking in order to assess relative marketplace perIormance compared with main
competitors. Benchmarking program measures would include monitoring key perIormance
indicators (KPI`s) such as quality oI advice, reliability, consistency oI service etc in terms oI
importance to customers. The objective is to gauge the Iollowing:
How do customers rate perIormance oI our Iirm in these areas;
How do customers rate perIormance oI key competitors.
Accuracy oI inIormation on members is a basic building block Ior almost everything that
happens in a pension arrangement. It is important thereIore that schemes have up to date record
keeping and administration systems that hold all the Iundamental common data required about
members. The most vital requirement Ior the service oI Axis will be the development oI a Iluid
database oI inIormation in order to create a distinct advantage over competitors. Into this
database would be input a series oI quantitative measures that monitor the KPI`s oI
stakeholders in the industry.
There are many indicators that can be selected Ior perIormance measurement other than
investment return. Monitoring the perIormance oI the Iund itselI is only part oI the overall
strategy Ior improving the Iinancial position oI the pension Iund. Cost reduction benchmarks
can also be used to ensure that the administration oI the Iund is more eIIicient. Costs can oIten
be diIIicult to identiIy and may be structured diIIerently Irom one European country to the next
in terms oI complexity. However, the underlying principles oI pension Iunds are essentially the
same in whichever country the scheme is located; therein it should be Ieasible to benchmark
administration associated costs.
The consultancy Iirm, Towers Watson, estimated that the total cost oI running a pension
scheme has risen by 50 over the last Iive years with the costs Ior large Iunds increasing on
average by 110bps, in comparison to 65bps in 2002. The Iigures also reveal the most recent UK
administration cost per member ratio Ior schemes under 2,000 members as being 97 (t112)
per annum Ior those using in-house administration services, and 101 (t117) per annum Ior
those using external administration. For larger schemes oI more than 10,000 members, the use
206
oI third-party administrators has resulted in an administration cost ratio oI 46 (t50) Ior in-
house systems and 39 (t42) Ior external administration (Moss 2010)
1
.
An additional member-to-staII ratio acts as a benchmark Ior a scheme`s eIIiciency and provides
indicators as to the levels oI manual or automated systems used in the delivery oI services.
Other metrics that can be benchmarked against industry peers include:
Transaction volumes
Related service-levels
Economies oI scale
Cost relating to the location
It is not possible to cover every base in terms oI measuring perIormance. However, a number
oI other costs that need to be benchmarked Ior pension schemes include custodian Iees in terms
oI the rate oI interest charged on the Iund cash balances and overdraIts, Iees related to Ioreign
exchange executions and the timeliness oI income collections such as coupon payments.
Monitoring oI all these tasks may result in the shaving oI 5bps in terms oI costs here and there;
however these seemingly small sums when added together produce signiIicant savings.
Qualitative sources of information
External advisory services are now seen as a value-adding Iunction that provides specialized
services to the pension sponsor. The Axis Strategy team have to provide a comprehensive range
oI consulting services on all aspects oI pension scheme administration that help meet the needs
oI today and the challenges oI the Iuture. These challenges require that the consultancy has the
most up-to-date inIormation on any changes in the company scheme design or the client
beneIits package that may aIIect their strategy.
In support oI quantitative measures, it is also necessary to have a series oI qualitative sources
that can be drawn upon Ior expert advice. This would include published white papers` Irom
policy think tanks such as the OECD, the EFRP and the CRO Forum. Change is an essential
part oI growth in the pensions sector. In order to respond quickly to market, industry or
legislative changes, a pension sponsor needs to be able to draw Irom the necessary expertise
and have access to the most up to date inIormation. For many pension schemes this is a
complex and time consuming task, which may be hampered by domestic culture or systems. It
is in this area that the demand Ior expertise is growing.
Sustainable competitive advantage
When there is a good match between critical success Iactors` and the pension-consultancy`s
initial position, it is important to create sustainable competitive advantage through the
concentration oI resources and improvement oI core competencies. Alternatively, iI it
transpires that there is a large gap between customer demands and the Iirm`s position in any
critical department, then the company should explore business areas where it`s competence
proIile better suits the market demand and expectations.
1
Moss, G. (Ed.). (2010, March 1). Benchmark and save. Retrieved Irom http://www.ipe.com//and-save34191.php?articlepage1
207
Ultimate success Iactors in the Iinancial industry are Iund perIormance and levels oI
communication related to the service. It is important that there is continuous interaction
between scheme sponsors, trustees and Iund advisors; to this end there is a need Ior the
development oI an early warning system that alerts the pension consultancy should it Iall short
on delivery oI critical success Iactors to the customer, or alternatively should it lag behind a
competitor in any given department. Diagram 22.9 below charts the competence proIile oI
competitor A (a small pension consultancy the green line) and B (a large pension consultancy
the blue line) against the requirements oI the customer (the red line):
Diagram 22.9: DeveIopment of an earIy warning system
1
The diagram highlights the core competence area oI market knowledge` Ior the smaller
consultancy, and displays the gap to the larger consultancy in terms oI product development
and personal selling. It is the task oI the small business to recognize this gap and seek to narrow
the diIIerences between the consultancy and its competitors by initiating change.
3. Balanced scorecard
A more holistic tool used Ior strategic planning and management is the balanced scorecard`.
This planning system is used to align business activities to the vision and strategy oI the
organization, improve internal and external communications, and monitor organization
perIormance against strategic goals. It was originated by Kaplan & Norton (1992)
2
as a
perIormance measurement Iramework that added strategic non-Iinancial perIormance measures
to traditional Iinancial metrics in order to give managers and executives a more 'balanced' view
oI organizational perIormance.
1
2
Kaplan, R. S., & Norton, D. P. (1992). Balanced Scorecard. Retrieved Irom http://www.balancedscorecard.org/es////.aspx
207
1
2
as a
1
2
207
1
2
as a
1
2
208
Kaplan and Norton explain that 'the balanced scorecard retains traditional Iinancial measures.
However, Iinancial measures tell the story oI past events, which may well have been an
adequate story Ior industrial age companies Ior which investments in long-term capabilities and
customer relationships were not critical Ior success. It is diIIicult to steer an organization
Iorward by simply looking through a rear view mirror`. These Iinancial measures are thereIore
insuIIicient on their own Ior guiding and evaluating the journey that inIormation-age
companies must make to create Iuture value through investment in customers, suppliers,
employees, processes, technology, and innovation.
The balanced scorecard tool was thus created to Iacilitate a rounded strategy that measures
perIormance at Iinancial and operational levels and thereaIter provide Ieedback on both the
internal business processes and external outcomes. The key drivers` oI the company are used
as indicators to help management identiIy what should be done and measured on a day to day
basis. With the continuous inIormation generated, the balanced scorecard acts as the nerve
centre` Ior translating strategy into action.
The balanced scorecard uses 4 perspectives on which it develops metrics, collects data and
analyzes it. The tool can be applied to the pension sector as shown in the diagram below.
Diagram 22.10 - The baIanced scorecard
Source: Adapted from The Balanced Scorecard by Kaplan & Norton
a) The learning and growth perspective
Knowledge is a major Iactor in the pension services industry; to this end it is the
individuals who are the key resources in a company. With technology, product
proliIeration and regulation in a constant state oI development, it is vital that a
Iramework Ior continuous learning is in place Ior pension consultants to equip
themselves with the necessary skills in order to deliver value. Metrics need to be put in
place that Ioster the essential Ioundations oI learning and growth such as training and
the smooth Ilow oI communication throughout the organization
209
b) The business process perspective
Measures must be designed Ior internal business processes in order to gauge how well
the business is running, and ascertain whether products and services meet the
requirements oI customers. These metrics are speciIic to the pension consulting industry
and will include data on the number oI clients, the type oI client and the range oI
products and services provided.
c) The customer perspective
As client satisIaction Iorces its way to the top oI the business agenda, pension
consultancies have to Iocus on becoming more customer-centric in the delivery oI their
services. In addition to Iund perIormance measurement, the development oI satisIaction
metrics can be a leading indicator oI Iuture success or decline. Such metrics would
include an analysis oI the diIIerent processes used to service customer groups in terms
oI communication and support activities.
d) The Iinancial perspective
The reporting oI timely and accurate inIormation is a priority Ior managers. Financial
data metrics will include risk assessment, cost-beneIit and value added analysis.
The balanced score card should thus be used as a tool by Axis to convert strategic vision and
objectives into enhanced perIormance.
Summary of research findings on preferences for the remuneration of outside consultants
A key element oI the relationship with the client is the payment structure. It is important that
this is communicated and understood by both parties so that the value oI the service can be
measured correctly. The survey revealed that 44 oI respondents preIerred a Iixed price
contract Ior consultants with a Iurther 31 showing preIerence Ior a time-related billing
structure (see Diagram below). Per capita and annual management Iees along with a transaction
based Iee approach were a Iavoured approach oI 12.5 oI those questioned.
Diagram 22.11: Remuneration of outside consuItants
Preferences for the remuneration of outside consultants
a. Fixed price contract 14 43.75
d. Time-related billing 10 31.25
b. Per capita and annual
management...
4 12.50
c. Transaction based fees 4 12.50
Total: 32
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Chapter 23 Challenges for consulting services
As pension Iund management becomes more complex, there is a greater demand Ior expertise
Irom Iund sponsors. Ever-changing legislation, improving governance and the demand Ior
liability-driven investment strategies have now made the traditional domestic equity/bond
approach which characterized pension Iund management in the past obsolete. The boundaries
diIIerentiating pension consulting and Iiduciary management are also becoming less clear as
competitors move in to occupy places and even collaborate at the pension Iund table. A pension
scheme may require a whole array oI specialist skills to meet its objectives; it is vitally
important thereIore that advisers are able to work together.
The challenge Ior consultants is to convince pension scheme trustees that they are equipped
with the necessary skills and experience to do the job eIIiciently. However providing consultant
services alone is not suIIicient; the winner will be the consultancy that can oIIer a complete
package oI services which include a choice oI suitable product along with access to a range oI
asset classes that are tailored to the needs oI the speciIic sponsor. Such an open-architecture
approach is best provided by an independent advisor without allegiance to any products or
Iunds. It is important to be impartial when selecting external managers in order to properly
align the interests oI the client with the product provider. To this end pension consultants
should seek a remuneration structure that includes a Ilat rate` Ior work associated with the
running oI the scheme, and perIormance-related Iees which provide an incentive to select the
best managers with the strongest strategies.
As the market Ior cross border pensions evolves there is an increasing demand Irom clients Ior
providers with both an advisory and Iund management background. However it is unrealistic
to presume that with such limited resources a boutique service could oIIer a total investment
and governance solution that would incorporate all the component parts oI custody, reporting,
analytics, and portIolio management systems. This arena will be populated by the major
advisory groups who will compete over mandates Ior the big pension schemes.
The role oI the smaller pension consulting group is moreover to continuously research the
market, challenging conventions, whilst developing new ideas and exploiting opportunities. As
opportunities Ior new business arise, the consultancy would move to conduct a cost/beneIit
analysis Ior the client on the basis oI the size and resources oI the scheme, and thereaIter report
on a pension product and strategy suited to their needs. A primary Iunction oI the consultancy
is to act as an intermediary between the client and the specialist providers, in the Iorm oI Iund
management groups, banks, custodians etc. It is important on the one hand to speak the same
language` as the providers, and on the other, to seek to Iorge a long term relationship with the
client through the saIeguarding oI their interests. The task Ior the intermediary is thus to
become a bridge between these two worlds.
Strategy and implementation
Strategy has come to the Iore in terms oI the context oI advice; ALM is now an integral part oI
the process oI ensuring that the pension Iund commitments to its members are met. With
market Iorces such as interest rates and currencies Iluctuating continuously, it is vital that
consultants recommend that a dynamic, mark-to-market approach is adopted to deliver the
liability-related strategic objectives. ALM is not simply a number-crunching exercise employed
by actuaries; it is necessary Ior the intermediary to Iully grasp the underlying reasons why
actuaries design models the way they do, and communicate this to client.
211
The challenges Ior pension consultants are not limited to the interpretation oI asset-liability
models. In the real world oI investment management, there are oIten knee-jerk reactions by
managers in terms oI tactical allocation strategy, irrespective oI how distasteIul this may be to
actuaries. Sometimes decisions need to be made Iast in a crisis situation as there is not enough
time to methodically calculate the range oI options put Iorward by actuaries. By the same token
it is important Ior intermediaries to recognize the conservative nature oI the actuarial proIession
which sometimes result in an unwillingness to give deIinitive advice.
An additional concern Ior pension consultants is in the area oI implementation, wherein
expertise is required Ior the process oI manager selection and asset management. Having
investment expertise alone is not suIIicient; it is necessary to recognize both the liability and
investment sides oI the asset management equation. There will always be a degree oI
disconnection between strategy and implementation. The role oI the pension consultant is to
manage the communication lines between all parties so that the right tactical decisions are
made. Problems that develop in this area are exacerbated when market volatility threatens the
security oI the balance sheet. This may unnerve trustees as they come under pressure Irom
sponsors to protect the pension Iunds ability to meet its long-term commitments. In such
circumstances it is important that trustees have bought into tactical asset allocation, particularly
iI the strategy involves hedging or the use oI derivatives. ThereaIter positions should be taken
on the basis oI sound reasoning rather than reactions to market conditions.
The challenge Ior the intermediary is thus to orchestrate a situation where the interests oI all
stakeholders are aligned and supported by a Iully integrated Iunding and investment strategy. In
order to achieve such a situation it is necessary to work with all the stakeholders over a
sustained period oI time. This involves nurturing relationships with actuaries, sponsors,
trustees and asset managers and being tuned in to the mechanics oI strategies at both the ALM
and implementation levels. The consultant thus acts a mediator between the various parties
helping to Iacilitate decision-making.
Consultants` role in governance
There is a lot oI room Ior improvement in the governing standards oI pension schemes in terms
oI the implementation oI a coherent strategy. The problem oI accountability in decision making
can be addressed by developing expertise internally as opposed to outsourcing to specialists.
However, where resource constraints mean decision-making has to be delegated, outside
consultants are oIten in a better position to take ownership oI those decisions and the structures
through which they trickle down to implementation. This is oIten the case in a multi-adviser
context (Steward 2010)
1
. The Iirst step in any consultancy relationship is to establish a
decision-making matrix` with roles and activities delegated across and between the multiple
advisors and client`s in-house management expertise. The governance structure in itselI needs
to be determined by capacity and resources and will not guarantee success or Iailure. However
any structure must be underpinned by the well-deIined ownership oI decisions and delegation.
It is possible Ior a pension scheme to outsource areas oI its strategy and implementation and
still have ownership oI the decisions in-house. In such a situation there is a requirement Ior a
1
Steward, M. (Ed.). (2010, March 1). Europes Pension Consultants. Rapid Change. Retrieved Irom http://www.ipe.com//europes-pension-
consultants-rapid-change34178.php?articlepage3
212
strong trustee board to consider the areas oI responsibility to be delegated and ensure that there
are no conIlicts such as the investment arm oI a consultancy not being able to action certain
strategies.
Clear ownership oI decisions helps to avoid conIlicts oI interest between multiple advisers and
maintain coherence between strategy and implementation. This can be achieved through the
application oI a hub and spoke` model with specialist service providers such as actuaries,
lawyers, tax experts, accountants, and investment experts reporting to a single consultant with
oversight responsibility, and yet not controlling` responsibility. The role oI control is
invariably kept in-house and separate Irom the other Iunctions.
Accounting standards in the UK have helped push liabilities onto corporate balance sheets and
therein triggered a series oI governance problems. This has led to the sponsor adopting more oI
a hands-on` approach in terms oI strategy as opposed to the trustee overseeing matters. With
pension Iund landscape awash with deIicits in one Iorm or another, sponsors may be reluctant
to delegate responsibility to trustees or Iiduciary managers when they themselves own the
liabilities and the cash contributions. The only solution is thereIore Ior managers and
consultants to be collaborative in their decision-making and in so doing make their contribution
to a strategy that considers all party interests. As the corporate pensions market becomes more
intricate, the opportunity presents itselI Ior consultants to acts as Iacilitators both vertically
along the spectrum oI strategy implementation and horizontally across trustees, sponsors and
specialist advisors.
Summary of research findings on the added value of outside pension consultants
29 oI the respondents to the survey Iound that they were mostly attracted by the specialist
area oI consultants when it came to examining added value. The importance oI getting to grips
with EU legislation was recognized by 20 oI pension Iund respondents when they rated the
understanding oI complex legislation as instrumental in the selection process oI hiring outside
consultants (see Diagram 23.1). It is envisaged that as the European workIorce becomes more
mobile, and risk management processes more regulated, the demand Ior expertise on pan-
European pension legislation will be at a premium. Consultants were also recognized as a
source oI product knowledge along with their ability to complete tasks more eIIiciently and
cost eIIectively.
Diagram 23.1: The added vaIue of pension consuItants
The areas of added value considered when selecting outside consultants.
a. Specialist area of consultant 17 28.81
d. Understanding of complex
legislation
12 20.34
e. Product knowledge 11 18.64
c. Greater efficiency 10 16.95
b. Cost 9 15.25
Total: 59
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Part VII
Conclusions
Events over the last Iew years have demonstrated the danger in underestimating the level oI
risk in Iinancial markets. The objective oI this research was to examine the structure oI pension
systems in Europe and analyse the level oI preparation oI pension schemes Ior the challenges
that lie ahead. These challenges include an ageing population, greater volatility in the markets
and increased regulation at the European level in order to limit the amount oI risk pension
schemes are exposed to. To this end the hypotheses was tested that 'the European pension Iund
industry is short on governance and sound risk management and therein will struggle to meet
its liabilities to members.
The research revealed that although pan-European pensions are a relatively novel idea, those
pension plans that have actually established cross-border schemes are discovering that the
legislation is quite complicated and have strived to seek outside assistance in order to keep up
to date with regulatory developments.
A detailed analysis oI existing pension Iund investment processes suggested that business
processes in the pensions industry were reasonably robust in practice. However the Iinancial
marketplace is much more complicated than the application oI theory alone would permit. A
much greater depth oI experience is needed, particularly in the area oI risk management.
The analysis also revealed that perIormance-related Iees play an instrumental part in the
remuneration structure oI Iund managers, and that pension scheme oIIicers appeared on the
whole to be comIortable with the level oI transparency oI such Iees. However the recent stock-
market collapse would suggest that such exuberance Ior generating lucrative deals by Iund
managers displays a lack oI judgment and understanding oI the historical impact and
consequences oI Iailure to the Iinancial system. Furthermore, there does not appear to be any
empirical evidence that would suggest that paying perIormance Iees to managers results in
greater returns over the longer term. On the contrary, investment appears to be a zero sum game
in that Ior every investor who beats the market there is invariably someone else who loses.
Given that there is a need, both economically and socially, to deliver pensions that help
members sustain themselves into their old age, it may be best to consider a more passive
approach to Iund management which would result in less oI a downside in terms oI risk.
A major problem Ior regulators is that there has been extraordinary growth in sophisticated
Iinancial instruments such as hedge Iunds and credit derivatives. This growth has been a
necessary development in the pensions sector in order to mitigate risk. Derivatives have been
used as a dynamic tool in the balancing oI pension Iunds. As reserves shrink due to the
underIunding oI pension schemes, managers are being Iorced to consider alternative asset
classes in order to secure their liabilities and ensure solvency levels over time. Derivatives have
a role to play in risk management strategy and are here to stay. It is necessary thereIore Ior
governments to Iace up to the complex environment oI pension provision and undertake a
continuous path oI reIorm that encompasses greater control over these complicated tools. To
this end, EU regulators have tried to come to terms with the challenge through the introduction
oI legislation on the prudent management oI pension schemes in accordance with the IORP
Directive and employment oI strict solvency requirements via the Solvency II Directive.
214
Many mistakes have been made by pension schemes in terms oI asset allocation and portIolio
management strategy. It could be argued that a soldier who has made no mistakes is invariably
a soldier who has won no battles. However, in order to steer pension schemes in the right
direction, it is necessary to be realistic about the outcomes that need to be achieved. In this
sense the commitment to the members is oI paramount importance. The research demonstrated
that the demographic changes in society have pushed the issue oI longevity to the top oI the
Iuture-concerns agenda. As a result, many Iund sponsors oIIering DB schemes have to
reconsider iI they can aIIord the type oI pension beneIits that this model oIIers to members over
the long term.
The recent developments in EU pension legislation have not had a big bang` eIIect with
regards cross-border pension activity. On the contrary, growth is more likely to be gradual as
companies negotiate the changing environment. The road Iorward Ior the pensions industry
may not be the invention oI some new all singing and dancing` product but moreover a long
journey wherein processes are improved incrementally.
As a result oI the demographic changes taking place in Europe, economies in the Iuture will be
very much dependant on the purchasing power oI the retired population. It is thus in the
national interest oI these economies to avoid a depressed or stagnated situation. There will
always be hurdles to overcome, whether they are risk management issues or the need Ior better
governance. As circumstances change on the ground, and new tools are developed by market
players to manage risk, it is the job oI legislation to ensure that pension schemes do not become
over-exuberant in their quest Ior proIit making.
215
Recommendations - Route map to the future
You dont need to have a pact with the devil to succeed in pension fund management'
In order to know where vou are going, vou need to know where vou have come from'
There is no silver bullet` in terms oI Iinding a deIinitive solution to the pension system issues
Iacing European Member states. The developing role oI occupational pension provision is
however pivotal to addressing the challenge Iaced by an ageing European population.
The task is indeed Iormidable when Iaced with an ever-changing political and economic
landscape. Change is oIten painstakingly slow; the pension inIrastructure cannot be dismantled
every 5-10 years and reassembled with the latest legislation and products built into the system.
A more coherent response is thus needed with answers evolving Irom all that went beIore. This
approach will require systematic thinking as there is no single application or Iactor that can
guarantee results. There is a need thereIore Ior a holistic approach. With this in mind it is
necessary to put Iorward a series oI recommendations that would clear a path through the
Iorest.
European pension legislation can be quite complex in nature; however regulation is not
something which pension Iund managers should be aIraid oI. The aim oI the legislation
is to gradually bring the European disparate systems together. The EU project itselI is
very much in its inIancy; it will thereIore take a number oI years to iron out all the
wrinkles in terms oI the cultural, economic and political diIIerences. The IORP
Directive on pensions and the Solvency II Directive on insurance products have only
recently been put in place and should be given time to work. As additional Ieedback and
new inIormation is Ied into the system, a more rounded legislative Iramework will
evolve that will encompass all oI the Iundamentals needed Ior constructing a Pan-
European structure. In order to develop a successIul pension model it is necessary to
Iocus on some oI the areas oI persistent weakness. To this end legislation needs to be
Iorced through to create a level playing Iield between the two Directives in terms oI
solvency requirements in order to secure the interest oI pension scheme members.
Developing a suitable reIorm Iramework is not about having excessive state control or
abandoning Iree trade. However there is a pressing issue to be addressed in the area oI
risk management. The recent collapse in conIidence oI the Iinance system would imply
that leIt to their own devices Iinancial institutions do not apply best practice`
initiatives. The Iailure oI selI regulation` in the pensions industry would suggest that it
is now time to impose more stern legislation. The objective oI regulation should not be
to create another layer oI bureaucratic legislation that would limit product innovation
and therein hamper possible returns. It is not designed to curtail out oI the box`
thinking but moreover to establish a suitable Iramework that cultivates the organic
growth oI pensions. It is thus necessary to have a regulatory apparatus that protects
pension stakeholders Irom reckless risk taking.
Regulation is not just about the introduction oI speciIic measures to improve existing
pensions systems. Pension Iund management should also be actively involved with the
regeneration oI Member State countries in terms oI investment in innovation, R & D,
and physical inIrastructure. There is a need to develop new rules, new laws, and new
216
norms to cater Ior the seismic shiIts in society. A key problem Ior Western European
countries is that their economies are mature; as such it is becoming more diIIicult to
compete with the developing world in terms oI cost and economies oI scale in the area
oI manuIacturing and services. An additional concern is the threat oI climate change
and the perils oI unchecked capitalism which have presented governments with the
challenge oI how to switch Irom an unsustainable economic order to a just and
sustainable one. To address these issues it is necessary to have a realignment oI
mindsets and attitudes with a view to a shared Iuture. History oIten illustrates that
interest` trumps ideas in the end; however the market has to be subservient to the ideals
oI society. Pension Iunds should thus be active in channeling investment into projects
that create sustainable growth in the real economy, rather than the expansion oI the
Iinance sector which is prone to asset bubbles. In this department the onus is on
governments to play a guiding role in terms oI legislation by oIIering incentives to
pension schemes to pursue given courses oI action with regards the investment oI Iund
assets.
Fund managers and consultants alike need to Iocus on adding value in terms oI their
services. Pension schemes are prepared to pay Ior services, but Iees need to be more
transparent and the value proposition measureable.
In order to promote the objective oI labour mobility in Europe, occupational pension
schemes need to address the issue oI portability accrued pension rights. New legislation
thereIore needs to be approved with a view to reducing the obstacles that hinder
workers Irom moving across borders more Ireely. Such a Iramework would Iacilitate
the transIer oI pensions Irom one employer to another, or Irom one product provider to
another, and also between the second pillar and third pillar pension systems.
Trustees are increasingly been given a signiIicant role to play in the governance oI
Iunds. It is important thereIore that pension schemes incentivize trustees to obtain
relevant proIessional qualiIications that keep their skills current with the latest
developments in the pension sector.
Ideas and new ways oI creating wealth are more important than ever beIore in the
development oI economic and business liIe. A high level oI creative thinking in the
Iinancial services sector arms Iund managers with new ways oI managing processes
and taking risk. However there is little to be gained by businesses competing with
each other to their ultimate extinction. Ideas can be shared across Irontiers at great
speed and multiply; real power is no longer in the retention oI inIormation at the
centre but moreover in the sharing oI it across all platIorms. Pension consulting
services can also make their contribution to this revolution in thinking.
The aim oI advisory services is to help the board oI trustees increase their grip on
asset management with particular emphasis on improving risk management
processes. The oIIer oI independent expertise on asset management will help
increase the collective knowledge on investment. The use oI an external consultancy
adds another layer oI control Ior trustees in that the scheme can beneIit Irom the
additional checks and balances that are oIIered by the advisor applications.
It is necessary that pension Iund management does not remain rooted in behavior and
responses designed Ior a diIIerent business climate. A strategy that was successIul Ior
yesterday`s trading conditions may not be the best course Iorward. Active investment
217
strategies have been largely unsuccessIul over the last 10 years in out-perIorming the
index. It is important thereIore that Iund managers employing such strategies come
under greater scrutiny and are asked to justiIy the high execution costs oI active
management. This is not to say that the ability oI skilled managers to add value through
active management should be disregarded; moreover pension Iunds should invite Iund
managers to explain the reasons why they think their chosen active strategy would yield
results and be asked to provide assurance that the necessary selection and monitoring
processes are in place.
There is no point in pursuing an elaborate exercise oI rearranging the deckchairs on the
Titanic. Fund managers oI underperIorming schemes should not remain stuck to the
burning deck`, but moreover Iocus on what to do in order to save the ship and make it
Iighting Iit Ior the battles ahead. It is important to anticipate and respond to the trends
in the liIe and pension industry in order to build a sustainable Iuture Ior the population.
Given the changing demographics, pension Iund managers need to Iocus more on a
liability driven investment approach, in order to ensure that schemes will be able to
IulIill their obligations to retired members. Such an LDI approach would be supported
by a predominately passive investment management strategy Irom the outset as this
would involve less risk being Iactored into the equation.
Ultimately, pension Iunds should adopt a twoIold policy oI an actively managed short
term portIolio oI assets using derivative instruments and a long term passively managed
LDI strategy that meets the obligations oI scheme members. However in order to
saIeguard against derivatives being mishandled, it is imperative that each scheme
maintains signiIicant solvency capital levels that act as risk management collateral.
The underIunding problem relating to DB plans in Europe has become acute as a result
oI the current Iinancial meltdown, with many schemes closing to new members. As
there is little sign oI reprieve oI the situation, there appears to be no point administering
Ioot-and-mouth vaccine to a dead cow; something diIIerent needs to be done. The crisis
thus presents Member State governments with an opportunity to tackle the DB problem
head on`. European governments should consider Iollowing the US model by
encouraging a shiIt to DC plans. To this end, participants oI DB schemes that are
terminated should be given the option to either receive a lump-sum` distribution oI the
plan proceeds or convert their accrued beneIits to DC schemes. Such a move would
mark the beginning oI the end` oI a DB culture which has proven to be exceedingly
expensive to sustain Ior employers.
Alternatives to traditional approaches are necessary to create the conditions under
which a single EU pension market can develop and Ilourish. There is a need to develop
an architecture oI ideas that Iinds an alternative way between state controlled systems
and Iree market capitalism; a socially conservative path Iorward. Should the push
towards DC schemes be too much oI a quantum leap` Ior EU governments then an
interim or partial solution should be considered under a hybrid structure. In so doing, a
win-win` situation could evolve where all parties inherited a portion oI the risk and
employers were not committed to the provision oI unsustainable beneIit schemes. The
process oI hybridisation would help smooth the transition Irom the polarized extremes
oI DB and DC schemes so that a broad solution can be developed Ior the 21st century
that is compatible, and acceptable to all member states.
218
As night Iollows day, things will always go wrong with regards pension portIolio management.
The industry moves with knowledge and makes advances on a gradual basis. In the short term
investment positions may seem Iragile iI sentiment is wary oI market volatility; it is important
thereIore that the management process is not just a box-ticking` technical exercise but
moreover Iocused on the long term interests oI all pension Iund members. The search Ior
solutions continues...
219
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Glossary of Acronyms and Abbreviations
ALM Asset Liability Management
BEL - Best Estimate oI Liabilities
CAPM - Capital Asset Pricing Model
CDP - Carbon Disclosure Project
CEA - Committee oI the European Assurance
CEIOPS - The Committee oI European Insurance and Occupational Pensions Supervisors
CRO - ChieI Risk OIIicer
DB DeIined BeneIit
DC DeIined Contribution
DNB - De Nederlandsche Bank (Dutch Pension Regulator)
ECB European Central Bank
EEA - European Economic Area
EFAMA - European Fund and Asset Management Association
EFRP European Federation Ior Retirement Provision
ERM Enterprise Risk Management
ERP - Equity Risk Premium
ESG - Environmental, Social and Governance risks
GDP Gross Domestic Product
1AS 19 - International Accounting Standard 19
IDV - Individualism-Collectivism (HoIstede`s cultural dimensions)
IFRS - International Financial Reporting Standards
IGC - Investment Governance Group
IORP - Institutions Ior Occupational Retirement Provision
IT InIormation Technology
KPI - Key PerIormance Indicator
LDI Liability Driven Investment
LIBOR London Inter-banking Rate
LTO - Long Term Orientation (HoIstede`s cultural dimensions)
MAS - Masculinity-Femininity (HoIstede`s cultural dimensions)
MCoC Market Cost oI Capital
MCR - Minimum Capital Requirement
MI - Management InIormation
MVA - The Market Value oI Assets
MVL - The Market Value oI Liabilities
MVM - The Market Value Margin
OECD Organization Ior Economic Cooperation and Development
ORSA - Own Risk And Solvency Assessment
PAYG Pay As You Go
PDI - Power Distance (HoIstede`s cultural dimensions)
PEST Political Economic Social and Technological
PPF Pension Protection Fund
QIS - Quantitative Impact Studies
SAA - Strategic Asset Allocation
SCR - Solvency Capital Requirement
SIP - Statement oI Investment Principles
SLL - Social and Labour Law`
SRP - Supervisory Review Process
SST - Swiss Solvency Test
233
SWOT Strengths, Weaknesses, Opportunities and Strengths
TAA - Tactical Asset Allocation
TP - Technical Provisions
UAI - Uncertainty Avoidance (HoIstede`s cultural dimensions)
UNPRI - United Nations Principles oI Responsible Investment
VaR - Value at Risk
234
Appendix 1
The Pension Siren - International pension survey
Welcome to our survey!
1. What saIeguards do the pension Iund trustees have in place to minimize risk?
This Iield is mandatory, You must enter a response in order to proceed.
a. Hold regular trustee meetings
b. Regular employer covenant review
c. Monitor perIormance oI investments
d. Regular review oI scheme advisors
e. Trustee training
2. When considering the Iuture oI the scheme, which oI the Iollowing concerns do you have?
a. Administrative challenges
b. Longevity risk
c. Need Ior liability driven investment
d. Risk management process
e. The commercial Iuture oI the sponsoring company
I. None oI the above
3. Which oI the Iollowing de-risking strategies have you considered in the last 12 months?
a. Buyout
b. Swaps
c. Longevity insurance
d. None oI the above
4. EU legislation with regards the governance oI cross border pension schemes is diIIicult to
understand.
235
a. Strongly agree
b. Agree
c. No opinion
d. Disagree
e. Strongly disagree
5. What are the areas oI added value considered when selecting outside consultants?
a. Specialist area oI consultant
b. Cost
c. Greater eIIiciency
d. Understanding oI complex legislation
e. Product knowledge
6. How do you preIer to remunerate outside consultants?
a. Fixed price contract
b. Per capita and annual management charge
c. Transaction based Iees
d. Time related billing
7. Which oI the Iollowing benchmarks do you use in the selection process oI an external Iund
manager?
a. PerIormance
b. Investment process
c. Risk Management process
d. Level oI Iees
e. Level oI reporting
I. The size oI the organization
g. We don't use external Iund managers
8. The Iees charged by external Iund managers do not seem to be transparent.
236
a. Strongly agree
b. Agree
c. No opinion
d. Disagree
e. Strongly disagree
9. What type oI investment strategy does your pension Iund manager employ?
a. A passive management strategy
b. An active management strategy
c. A core/satellite approach
d. A liability driven investment strategy
e. Other
10. Do you plan to increase exposure to any oI the Iollowing asset classes in the next 12
months?
a. Emerging Markets
b. Green Iunds
c. Long term bonds
d. Private equity
e. Commodities
I. InIrastructure
g. Property
h. Hedge Iunds
I would like to receive the Iindings oI this survey
Yes
No
237

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